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Yahoo's Alibaba Spinoff Is in Tax Limbo

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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Yahoo owns a bunch of appreciated stock in Alibaba. It would like to give that stock to its shareholders without incurring any tax. Just giving the stock directly to the shareholders would incur tax. But putting the stock into a nice little package, and then giving the package to the shareholders, could avoid tax, depending on whether Yahoo constructs the package correctly and mutters the right incantations over it. So Yahoo put the stock (along with Yahoo Small Business) into a package called Aabaco Holdings, typed up a draft of the incantations and went to the Internal Revenue Service to ask if they were right.

The answer it was hoping for was "yes." "No" would have been a worse answer, but at least an informative one. Maybe it could take another crack at the incantations, or, at worst, move on to other projects.

But the IRS's answer was basically to lock the door, yell "we're not here," and then dig a tunnel out the back to escape. It refused to say yes, refused to say no, and "announced that it was reconsidering its ruling policy" in the hopes that no one would ask it a similar question ever again. The office of answering this particular question is closed indefinitely. This is a much worse answer than "yes," and looks sort of ugly even compared with "no."

Now. The IRS reviews, or at least used to review, spinoff incantations just as like a favor to people who share its enthusiasm for tax arcana. Unlike in antitrust law, there's no actual requirement that you ask the IRS for approval before doing a tax-free spinoff. Yahoo can just do the spinoff and see if anyone complains. If the IRS does complain -- and, again, it hasn't said that it would -- then Yahoo and the IRS will go to court and argue over whether Yahoo's incantations worked or not.

This is not a question susceptible to a definitive answer, but there are signs that Yahoo got it right. For one thing, it has the continued blessing of Yahoo's tax advisers at Skadden Arps, who know from tax incantations, and who confirmed to Yahoo, that the IRS's silence "would not affect Skadden’s ability to render an opinion that, under current law and subject to certain factual representations and assumptions, the currently proposed spin-off will satisfy all of the requirements for tax-free treatment."

For another thing, similar incantations have worked before. We've talked about Liberty Interactive's 2014 spinoff of its shares of TripAdvisor in a package containing those shares and BuySeasons, an online costume business. That happened before the IRS stopped opining on spinoffs, and Liberty got an IRS ruling providing that the TripAdvisor spinoff would be tax-free.  The Yahoo/Alibaba situation is different, but not very different; in both cases, Liberty/Yahoo would spin off a big pot of appreciated shares in a publicly traded company (TripAdvisor/Alibaba) combined with a small active business (BuySeasons/Yahoo Small Business). In both cases, the business purpose would be to separate the public stock from the core business so that Yahoo, like Liberty, could trade without the overhang of another public company. In both cases, the active business included in the package is small and weird, but if it was good enough for Liberty, why shouldn't it be good enough for Yahoo?  

But the IRS seems to be at least thinking about changing its views. As Yahoo said yesterday, the IRS has "formally announced that it was studying potential new administrative guidance with respect to certain issues under Section 355 of the Code" relating to spinoffs. The announcement -- which came in July, well after Yahoo announced its spinoff plans -- said that the IRS is considering:

Guidance relating to the requirements under §355, including the active trade or business and business purpose requirements and the prohibition on device for the distribution of earnings and profits.

The idea is that a spinoff can only be tax-free if it includes a sufficient "active trade or business" (like Yahoo Small Business), and if it is not a  "device" to distribute profits (like the appreciated Alibaba stock) to shareholders. Those requirements are necessarily a bit fuzzy, and people are concerned that the balance that the IRS has historically struck is a little too favorable to tax avoidance. Isaac Zimbalist, who delights in the title "branch 5 senior technical reviewer, IRS Office of Associate Chief Counsel (Corporate)," was pretty forthright about this in May:

Zimbalist said the IRS is "getting grief" from those outside the agency about rulings in which a hot dog stand was essentially dropped into a business that primarily consists of publicly traded stocks, cash, and similar assets. "We have to study it. We have to respond to it. And we're putting people on notice that that's what's going on," he said.

If you squint, Yahoo Small Business looks a bit like a hot dog stand. And a lot of people are squinting! It turns out that Yahoo gets a lot of attention,  and that its proposed transaction to save about $9 billion in taxes by Krazy Gluing a tiny business to a pot of Alibaba shares has rubbed some people the wrong way. And those people have given the IRS grief, and the IRS, as part of its grieving process, is thinking about changing the rules. It is just doing that thinking slowly.

Now in many ways, that is exactly how this is supposed to work. There is a law.  People observe the consequences of that law. They think the consequences are bad. The law does not do what the people want. Those in power ponder the people's desires, in their wisdom. The law is changed. Now the law does what the people want. The people rejoice.

But imagine being Yahoo's board. You've got a fiduciary duty to your shareholders. It's pretty clear that a tax-free spinoff of the Alibaba shares is the best thing for Yahoo shareholders. The shareholders think it, the board has admitted it, the stock price reflects it. (Er, reflected it.) To shut down the spinoff now, when your lawyers and many outside observers continue to think that it would be tax-free, is awkward to square with your fiduciary duties. On the other hand, going ahead with the spinoff, finding out later that it was taxable and sticking shareholders with a $9 billion tax bill would be an almost unimaginable disaster.  Either way you run a huge risk, of looking like a coward or a fool, respectively.

Wouldn't it be nice for the board to know the answer before making an irrevocable decision? Wouldn't it have been nice for the board to know the answer before announcing the spinoff? Or even before being lobbied by shareholders to do a tax-free spinoff? Wouldn't it be nice, generally, for companies to know what the rules are before they make huge important decisions?  

It is just a feature of American financial regulation -- of American law, really -- that the rules are often decided in hindsight, one controversy at a time, by punishing the last guy who did something controversial rather than by announcing that the next guy to do it will be punished. The bond-trader dishonesty that we talked about yesterday is a popular example: Bond traders had a habit of trying to put one over on their customers. The government decided that that would no longer fly. But rather than announcing, "Hey, that will no longer fly, make a note of it," the government instead is trying to put a few bond traders in prison. The idea is that the rest of the bond traders will definitely make a note of that, though it's a bit rough on the ones who go to prison.

The IRS isn't going that far. It's actually trying to change the rules in advance; it's studying the issue and considering new guidance on how to make a spinoff tax-free. But while it's pondering that decision, pending spinoffs are in a weird limbo: The old rules no longer have the wholehearted endorsement of the IRS, and nobody knows yet what the new rules will be. So one tax lawyer "said he would urge the company to move sooner rather than later in the event the IRS decides to change its policy," since the new rules might turn out to be worse than the disfavored old ones. But that too would be a gamble, a bet that the spinoff rules are still what they were, instead of what they're going to be. It's not really clear that that's how it works.

  1. As Yahoo puts it, "the IRS indicated that it had not concluded that the proposed spin-off transaction was taxable and therefore was not ruling adversely on the request."

  2. That's Yahoo's language from its 8-K yesterday. The IRS's language is actually vaguer:

    The IRS Office of the Associate Chief Counsel (Corporate) announced May 19 that it may hold in abeyance any new letter ruling requests involving some section 355 tax-free spinoff active trade or business (ATB) requirement questions while it studies how much ATB is enough.

    The IRS hasn't decided how to handle affected rulings that have already been submitted or whether the change of course will turn into a guidance project. Affected rulings already in-house will "continue to be handled in the normal fashion for now -- but this may change," said Isaac Zimbalist, branch 5 senior technical reviewer, IRS Office of Associate Chief Counsel (Corporate).

  3. Liberty says that on, e.g., page 12 of the S-1. The IRS's private letter rulings are given anonymously, but here is a private letter ruling with about the right date and facts, which Tax Analysts calls "a recent letter ruling (LTR 201435005) blessing what is believed to be the spinoff by Liberty Interactive Corp. of TripAdvisor Inc."

  4. That is the sort of argument that lawyers love. Consider tax consultant Robert Willens:

    Yahoo would probably go to court to challenge the decision, and Mr. Willens said the company would most likely prevail. The rules governing the size of the operating business in this kind of spinoff have long been cemented in precedent, he argued, and should not be changed on a whim. Any auditor who raised the issue would be “adventurous.”

    On the other hand, those precedents can themselves look a little whimsical. IRS private letter rulings -- like the one blessing the Liberty transaction -- come with a disclaimer saying that "This ruling letter is directed only to the taxpayer who requested it" and that "it may not be used or cited as precedent." There is perhaps a nudge-and-wink quality to that disclaimer -- those letters get released publicly, and read by audiences beyond their original requesters -- but still, you cannot technically hold the IRS to its previous positions.

  5. Some of it shockingly misogynous! How bout that.

  6. Or whatever, a thing, let's call it a "law," without being too doctrinaire about what that word means. What "officials do about disputes is, to my mind, the law itself," says Karl Llewellyn.

  7. It is no answer, by the way, to say that Aabaco will have to indemnify Yahoo for any tax liability under a Tax Matters Agreement in connection with the spinoff. (It will: See pages 22-24 of the spinoff prospectus, which describes an allocation of spinoff-related taxes to Aabaco in most circumstances.) The point is that right now Yahoo shareholders have stuff, and if Yahoo divides up the stuff in a way that subtracts $9 billion worth of value, then that is bad for current Yahoo shareholders, regardless of where exactly the subtraction occurs.

  8. Or there's a third choice, of doing something to monetize the shares that was not your preferred approach:

    Mark May, an analyst at Citigroup, said: “We believe it’s unlikely that the spin-off will take place as previously contemplated.” He said Yahoo could now consider a spin-off of its core business or a sale to a strategic acquirer.

    Or oh hey I don't know maybe a sale to Alibaba? That is my preferred trick, though perhaps no one else's.

  9. Here is a take to that effect: "Capitalism Needs The Rule Of Law, Not The Whim Of Bureaucracy, To Function."

  10. Of the common law, really. Again Llewellyn is instructive.

  11. "Rules" is again a loaded term that I am not using in its technical sense. The IRS is reconsidering its guidance, not its rules.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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

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