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Yahoo May Not Get Rid of Alibaba So Easily

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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We talked a while back about Yahoo's plan to spin off a portion of itself, cleverly referred to as SpinCo. SpinCo would do two things. One thing it would do would be to hold on, very carefully, to 384 million shares of Alibaba stock (currently worth about $34 billion) that Yahoo would entrust to it. The other thing it would do would be: something else. Whatever! It was literally a business to be named later: When Yahoo announced the spinoff, it called the business "a legacy, ancillary Yahoo business."

The point of attaching the legacy business was that, for a spinoff to be tax-free, it needs to involve an active trade or business: You can't just spin off a pile of stock in another public company. So Yahoo attached a legacy business to its pile of stock in another public company, to make the spinoff of that pile of stock tax-free.

Eventually Yahoo Small Business announced that it was the lucky legacy business that was getting spun off. Yahoo Small Business put a brave face on it, and I wished it all the best, but, come on. The whole point of the spinoff is to get the Alibaba shares into as pristine a box as possible without paying taxes on them. Once they are in a pristine box, various cool possibilities open up. SpinCo could trade as effectively an Alibaba tracking stock, providing a way for people to invest in Alibaba at (presumably) a discount to the price of regular Alibaba shares. Or, eventually, Alibaba could buy SpinCo. Alibaba could hand out, say, 364 million shares of Alibaba to SpinCo shareholders, acquire SpinCo and then park SpinCo's 384 million shares on Alibaba's balance sheet. For all practical purposes that would retire the shares, meaning that Alibaba would have issued 364 million shares, canceled 384 million, and effectively bought back 20 million shares for free. 

All of those plans assumed a pristine box full of Alibaba shares. From the perspective of those plans -- plans for a tax-efficient monetization of Yahoo's big pile of Alibaba shares -- Yahoo Small Business looked like a small smudge on the otherwise pristine box. Making that smudge look smaller makes the box more attractive. And so Yahoo did a lot to minimize the smudge. For one thing, if you want to emphasize that the business you're attaching to SpinCo is small one, having "Small Business" in the name helps. "What business is Yahoo attaching to its Alibaba shares?" "Oh, don't worry about it, just a small Yahoo business. A Yahoo Small Business, even." 

For another thing, I mean, it is small. Yahoo Small Business seems to have adjusted earnings before interest, taxes, depreciation and amortization of about $50 million a year, representing about 4 percent of Yahoo's adjusted Ebitda. Yahoo is spinning off only a tiny, tiny slice of its actual operating business in SpinCo. The overwhelming majority of Yahoo will stay with Yahoo, and the overwhelming majority of SpinCo will be Alibaba shares. Yahoo Small Business will be a small accidental token passed between them. 

This is all very obvious. Not like "I am so clever so I noticed this" obvious, but like, "Yahoo kept saying it" obvious. The cover page of Yahoo's presentation said "Plan for Tax-Free Spin-Off of Alibaba Group Holdings." The presentation referred to Yahoo Small Business as "a legacy, ancillary, operating business," doubly minimizing its importance, or as "Active Trade or Business" (or "ATB"), a tax term of art. Yahoo's message was crystal clear: What's happening here is, we are giving you some Alibaba shares, and we're not paying taxes when we do it. In order to check a certain box on a certain Internal Revenue Service form to make everything tax-free, we will also be handing you this other thing. We don't want to give you the other thing, and we know you don't want it, but trust us, the tax rules are complicated and they require us to give you the thing. But don't worry about it. It's a pure formality, not to be taken seriously.

That strategy ... seems maybe to have backfired?

Isaac Zimbalist, senior technician reviewer at the IRS Office of Associate Chief Counsel (Corporate), said on Tuesday that the agency is considering changes to rules concerning spinoffs. The Internal Revenue Service will hold off on requests for rulings that are received starting Tuesday as the issue is studied, he said at a D.C. Bar Association event. Requests already received will move forward, but that is subject to change. It wasn’t clear what would happen to requests, such as Yahoo’s, that are already in the pipeline.

“The issue comes down to whether we’ve dropped a hot-dog stand or a lemonade stand into a business that is primarily publicly traded stocks, cash and other wonderful things that I call appreciated property,” Zimbalist said.

Yahoo's stock was down 7.5 percent on the news, which has implications for Yahoo's spinoff that are ... unclear but, you know, not obviously positive? Alibaba's stock was up, presumably as some spinoff arbitrageurs unwound long Yahoo/short Alibaba trades. Yahoo Small Business is not literally a hot-dog stand; nor is it literally a costume business, like the "active trade or business" that Liberty Interactive once used to justify a tax-free spinoff of TripAdvisor shares. But it is ... you know, small. "Small and despised," as I repeatedly called it when we talked about this spinoff in January.

I said at the time:

This is a tax dodge. That's fine! It's an open and transparent and well understood and perfectly legal tax dodge. In fact Yahoo expects to get "a favorable ruling from the Internal Revenue Service with respect to certain aspects of the transaction and a legal opinion with respect to the tax-free treatment of the transaction." Yahoo isn't hiding anything. It's asking the IRS for its blessing.

And it's not even pretending that this is something other than a tax trade. It doesn't have to! A tax-free spin-off requires Yahoo to recite certain magic incantations -- "business purpose," "active trade or business" -- in the right order and with the right pronunciation. But it doesn't have to mean them. The incantations, on their own, are enough to work the magic.

WELL, OOPS! You can see why Yahoo expected a favorable ruling. The incantations are usually enough to work the magic. The IRS is normally a pliable genie, easily moved by precedents and magic words. But if you make it too obvious that you're doing the absolute minimum to get tax-free treatment -- if it's too clear that your spinoff is about just saying the right words to avoid $16 billion of taxes -- then even the IRS might get fed up. Who knew? 

  1. See page 39 of this memo from Wachtell, Lipton, Rosen & Katz, my former employer:

    Under Section 355, the parent must distribute “control” of the spin-off company (generally, stock representing 80% of the voting power and 80% of each non-voting class of stock) and must establish that any retention of stock or securities is not pursuant to a tax avoidance plan. In the spin-off, the parent can distribute stock or stock and securities of the spin-off company, and the distributees can be shareholders or shareholders and security holders. In addition, the parent and the spin-off company must each satisfy a five-year active trade or business test (i.e., immediately after the spin-off each of the parent and the spin-off company must be engaged in an “active trade or business” that was actively conducted throughout the five-year period before the spin-off, with certain exceptions).  

  2. See footnote 5 here. The $50 million adjusted Ebitda comes from the spinoff announcement call; the $1,362 million adjusted Ebitda for all of Yahoo comes from page 43 of the 10-K

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net