How Yahoo plans to save $16 billion in tax on Alibaba stock

Yahoo is taking advantage of a loophole in the tax code to spin off its $40 billion stake in Chinese e-commerce giant Alibaba to shareholders without paying about $16 billion in corporate income tax.
That’s how much Yahoo would pay if it sold its Alibaba shares or transferred them to directly shareholders.
Instead, Yahoo is setting up a registered investment company, dubbed SpinCo, that will hold its remaining 384 million shares of Alibaba and a “legacy ancillary business.”

The legacy business, which Yahoo has not identified, is the key to tax avoidance. It doesn’t matter how small it is, as long as Yahoo has operated it for at least five years before the spin-off, said Wall Street tax expert Robert Willens.

Yahoo said it expects the deal to close in the fourth quarter. At that point, Yahoo shareholders will receive stock in SpinCo, which will trade as a separate public company. When they sell SpinCo shares, they might owe capital gains tax, depending on how much they paid for their Yahoo stock. But the tax-free spin-off Yahoo announced Tuesday, if approved, will avoid double taxation at both the corporate and shareholder level.

Here’s the math: Yahoo’s 15.4 percent stake in Alibaba, which it acquired for almost nothing, is worth about $40 billion.

If it distributed its Alibaba stock directly to shareholders, Yahoo would recognize a gain of almost $40 billion. On that, Yahoo said, it would pay roughly $16 billion in corporate income tax. (This assumes a tax rate of 40 percent, which could include state taxes considering the top federal rate is 35 percent.)

At the time of the distribution, its shareholders also would be taxed on $40 billion in dividend income, at a top rate of 23.8 percent (including the 3.8 percent Medicare surcharge on high-income earners). If their Alibaba stock appreciated further, shareholders would be taxed on the incremental gain when they sold it.

However, Section 355 of the tax code allows companies to spin off subsidiaries without incurring any tax at the corporate level (or an immediate tax at the shareholder level) if certain conditions are met.

One is that the transaction must have a business purposes. To satisfy this requirement, Yahoo could argue that the value of Yahoo and SpinCo shares combined will be higher than Yahoo stock alone if it never did the spin-off, Willens says.

The other is that the spun-off company must have an active business. If SpinCo held nothing but Alibaba stock, it would not meet the active business requirement and Yahoo would owe the corporate-level tax, Willens said. “That is why they are putting the legacy business in. It’s undoubtedly going to be small. It doesn’t have to be a certain size as long as it is an active trade or business conducted by Yahoo for at least five years.”

The legacy business could be something like struggling photo-sharing service Flickr, which Yahoo acquired in 2005, or something even tinier and more obscure.

Yahoo is adopting a strategy pioneered by John Malone’s Liberty Interactive, which spun off its stake in TripAdvisor into a separate company called Liberty TripAdvisor Holdings last year. To meet the active business requirement, Liberty put Buyseasons, an online costume seller, into the new company.

Willens said Liberty got a private-letter ruling from the Internal Revenue Service approving the tax-free spin-off.

In its announcement, Yahoo said the spin-off is subject to certain conditions, including “receipt of 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.”

Willens believes that if the spin-off is approved, Alibaba eventually will acquire SpinCo, essentially buying back its shares but at a discount to its market value.

He points out that in the Liberty deal, Liberty made it clear that one of the “business purposes” of its spin-off was to facilitate an acquisition of Liberty’s controlling stake in TripAdvisor by TripAdvisor.

Presumably, if Alibaba acquires SpinCo, it will issue to SpinCo shareholders a smaller number of shares than it acquires. For example, if Yahoo puts its 364 million Alibaba shares into SpinCo, Alibaba might acquire SpinCo for 330 million Alibaba shares. The discount is Alibaba’s “fee” for participating in Yahoo’s tax-savings scheme, Willens said.

If that is indeed the endgame, Yahoo can’t say so.

The key is to make sure the spin-off and subsequent acquisition of SpinCo by Alibaba “are not part of a plan. If they are found to be part of a plan,” the acquisition by Alibaba “will cause the spin-off to be taxable,” Willens said.

It would be considered part of a plan if Yahoo and Alibaba “agreed to or substantially negotiated” the acquisition before the spin-off, he added.

Lee Sheppard, a contributing editor with Tax Notes, predicts that the Internal Revenue Service will approve the deal, even though she sees problems with it. “The IRS is generous on this issue,” she said.

If the deal goes through, California could be missing out on tax revenue, since it conforms to Section 355 of the federal tax code. California’s top corporate tax rate is 8.84 percent. On $40 billion, that amounts to about $3.4 billion. However, it’s not clear whether Yahoo holds its Alibaba stake in a California subsidiary, and if it does, whether it has tax losses it could apply against its gain. Yahoo did not respond to requests for comment.

If the deal goes through, Yahoo shareholders won’t owe tax until they sell their shares. Their cost basis — what they originally paid for their Yahoo shares — will be split between their remaining Yahoo stock and their new SpinCo stock, based on the relative value of the two companies immediately after the separation, says Richard Pon, a San Francisco CPA.

For example, suppose you paid $30 for one share of Yahoo. Immediately after the spin-off, Yahoo is worth $5 and SpinCo is worth $40, for a total of $45. You would allocate 11 percent of your cost basis, or $3.30 to your Yahoo shares and 89 percent, or $26.70, to SpinCo. If you then sold your SpinCo for $40, you would recognize $13.30 in capital gains. Your holding period (long-term or short-term) would be based on when you purchased the Yahoo share, not the date of the spin-off.