Yahoo (YHOO) recently amended its N-2 filing indicating that it is proceeding with the spin-off of its Alibaba stock (NYSE:BABA) to be transferred to a newly-formed registered investment company, Aabaco. Yahoo has also reported that it will be receiving a tax opinion from one of the top internationally-recognized M&A law firms, Skadden, Arps, Slate, Meagher & Flom LLP ("Skadden"), concluding that the spin-off will qualify for tax-free treatment. The trading price for the Yahoo stock has barely reacted to this news and continues to reflect pricing metrics that are treating the spin-off as fully taxable. This mispricing is based upon a misunderstanding of the likelihood that the spin-off will be made taxable following IRS audit and litigation. In this letter, we briefly describe why this risk has been inflated as a result of comments relying upon general premises rather than any serious analysis of Yahoo's facts. A more robust analysis shows that the risk of taxation is low, and that accordingly Yahoo is undervalued.
First, the risk that the IRS will challenge the spin-off is low. If the IRS did not like the spin-off, it could have stopped it easily, but it has chosen not to do so. In response to Yahoo's request for a PLR providing that the spin-off satisfied the active trade or business requirement for tax-free spin-off treatment, the IRS could have issued an adverse PLR instead of declining to rule on the transaction. An adverse PLR would have expressed a public IRS view that the transaction would not qualify as a tax-free spin-off. Moreover, the IRS could have issued a retroactive Notice of Proposed Rulemaking ("NPRM") describing regulations that it would issue to prevent transactions such as the Yahoo spin-off from qualifying for tax-free treatment. The IRS has statutory authority to promulgate regulations retroactive to the date when it issues an NPRM (or other notice) substantially describing the regulations that it will issue. Instead, on September 14, the IRS issued a revenue procedure and a notice that did not describe potential regulations to be issued in the future. This generally prevents the IRS from promulgating spin-off regulations retroactive to September 14, as confirmed by Bob Wellen, IRS associate chief counsel (corporate), in his statements that the notice "is by no means a description of future guidance," and that "[t]here is nothing in this notice that would suggest a retroactive effective date."[i]
Even if the IRS were to challenge the spin-off on audit and in litigation, its chance of success would be very low. As stated above, Yahoo has publicly reaffirmed the fact that Skadden will issue an opinion with respect to the spin-off. This means that in the view of a top-ranked international law firm, there is between a five and 15 percent chance that the IRS would win if it challenged the transaction. The Skadden opinion represents the reasoned conclusion of a top M&A law firm with respect to an issue on which it has opined numerous times. This not only decreases the likelihood that Aabaco (the indemnifying party in the spin-off) would ever have to pay tax, it also makes the IRS even less likely to ever challenge the transaction because, given its resource constraints, the IRS rarely takes on a challenge with such a low chance of success.
Further highlighting the IRS's low likelihood of success in challenging the tax-free nature of the spin-off is the fact that Yahoo has a very strong business purpose for spinning off its Alibaba stock. All things being equal, a spin-off is much more likely to qualify for tax-free treatment if it has a strong business purpose. We have previously written about Yahoo's business purposes for the spin-off, many of which are of a type that has been recognized in published IRS guidance as strong non-tax business purposes supporting tax-free spin-off treatment.[ii] One important business purpose not yet addressed publicly relates to Yahoo's need to make sure it is not characterized by the SEC as a regulated investment company ("RIC"). Yahoo's Alibaba stock and the assets held by its Yahoo Japan business put it at significant risk of becoming an investment company under the 1940 Act because they have caused Yahoo to hold publicly-traded securities that represent over 95 percent of the value of the company. If Yahoo does not separate its core business from its stock, it is at risk of becoming an investment company that would no longer be permitted to own an operating business and would be required by law to break up while complying with a set of complicated regulations. The spin-off solves this issue by divesting Yahoo of its Alibaba stock in the form of Aabaco, which will itself be a RIC. The very strong business purpose arising from the corporate restructuring needed to preserve Yahoo's ability to operate its business is a factor that, when considered together with Skadden's tax opinion and other factors favoring tax-free treatment, make it very unlikely that the IRS would prevail if it attempted to argue that the spin-off was taxable.
Based on these facts and our discussions with tax counsel with expertise in spin-off transactions, we believe that there is no more than a 20 percent chance the IRS would one day challenge the tax-free nature of the spin-off on audit and in litigation. Putting this together with the IRS's approximately 10 percent chance of success in court, there is a two percent (i.e., 20 percent x 10 percent) chance that the spin-off will result in a tax liability payable by Aabaco. Taking this probability into consideration, one can propose to account for the effect of a potentially taxable spin-off on the value of the Yahoo stock. Assuming that there is a two percent chance of taxation at a rate of 40 percent, and that Yahoo holds 384 million Aabaco shares at a price of $60 per share, the effective tax cost of the transaction is approximately $184 million (384 million x $60 x 40 percent x 2 percent), representing less than a one-percent discount on the value of Yahoo. Public holding companies such as Aabaco tend to trade at a 15 percent discount to their net asset value.
Importantly, any theoretical tax risk would likely occur many years in the future. The IRS is resource-constrained and only finished the 2009 and 2010 audit of Yahoo this year. Yahoo won't even file its 2015 tax return until around September of 2016. If the IRS were to then challenge the spin-off on audit, and Yahoo chose to litigate the issue, it could be several more years before the matter is resolved in a way that requires Aabaco to pay additional tax. Thus, any tax cost arising from the spin-off would likely be imposed long after Aabaco holders have sold their positions. Indeed, there is a likelihood that Aabaco will no longer be in existence at such time because it will have been absorbed by Alibaba. In any event, the distant theoretical potential of a tax liability should not materially impact current trading in Yahoo or Aabaco if properly discounted.
In the unlikely event that the IRS successfully challenges the spin-off as a taxable transaction many years in the future, there is another reason why the liability for such tax is unlikely to affect ordinary traders. If the IRS challenges the transaction and successfully argues that it fails the device requirement for tax-free spin-off treatment, holders of Aabaco stock could technically be treated as if they received a dividend equal, in the aggregate, to the value of Aabaco. However, we believe it is unlikely that the IRS would impose tax on ordinary-course, small holders of stock received in a public spin-off if it successfully treated the spin-off as a taxable transaction. The administrative cost and burden required for the IRS to identify and calculate the tax deficiencies for each public shareholder of Yahoo stock would generally outweigh any likely recovery for the IRS. We're unaware of any similar case where the IRS has pursued a large group of public shareholders years after a spin-off.
In summary, if the IRS did not like the spin-off it could have stopped it easily. When considered in conjunction with other factors, we believe that the likelihood of an IRS challenge to the tax-free nature of the spin-off is both distant and unlikely. Even if the IRS were to challenge the transaction, it would be unlikely to succeed in the face of a tax opinion from Skadden and a very strong business purpose. Not all tax risks are the same, and when we quantify the level of tax risk we have to boost the less than one percent discount we computed to 15 percent to get to a level typical of holding companies. We see a 15 percent discount to net asset value for the Aabaco spin-off, in keeping with the customary discount applied to holding companies, and we also foresee a post-spin-off takeover of Aabaco by Alibaba. It's time to stop the unfavorable tax conjecture and focus on the favorable tax reality!
[i] Amy S. Elliott, ABA Meeting: Guidance with New Thinking on Small ATBs Won't be Retroactive, 2015 TNT 183-2 (Sept. 22, 2015).
[ii] For further discussion of Yahoo's other business purposes for the spin-off, see our earlier discussion.
Disclosure: I am/we are long YHOO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Special thanks to my attorney Richard L. Stone, Esq for his direct contribution to this article and his related invaluable legal advice. The information contained herein does not constitute an offer to sell, or a solicitation of an offer to buy any security or otherwise enter into any transaction. Before making an investment decision consult with tax and legal counsel and a financial advisor to determine your suitability. This information does not purport to be complete and is no guarantee of future results. In evaluating the information, you should know that it could have been previously provided to other persons who could have already acted on it. An investor should not invest unless it is prepared to lose all or a substantial portion of its investment. Sutton View Capital LLC is organized in the United States under the laws of the State of Delaware, which laws limit the personal liability of members, including but not limited to the author.