Yahoo’s Spinoff Plan Could Be Risky Business

Marissa Mayer, chief of Yahoo, at a panel discussion in San Francisco.

The Yahoo board is reconsidering ways to increase its languishing stock price, including a possible sale of the core platform and advertising business. Most of the value of Yahoo’s stock is locked up in its $32 billion stake in Alibaba, and for almost a year, the board has focused on trying to dispose of those shares without paying taxes.

In January, Yahoo proposed distributing the Alibaba shares to shareholders, using a newly formed company, Aabaco, as a vehicle for the distribution. If the deal qualified as a tax-free spinoff, Yahoo shareholders would receive the Aabaco shares tax-free, and Yahoo would avoid roughly $10 billion in capital gains taxes it would have to pay if it sold the Alibaba shares outright.

The spinoff plan is in trouble. On Nov. 19, Starboard Value, an activist hedge fund, wrote a letter that urged the board to abandon the spinoff. The best alternative, according to Starboard, is to explore a sale of the core business, leaving behind the Alibaba stock and other investment assets in Yahoo. Disposing of the core business in a taxable sale would create a modest amount of tax liability, but Yahoo’s $10 billion in unrealized tax gain on the Alibaba shares would be deferred indefinitely.

The board’s willingness to listen to Starboard reflects lingering doubt about the tax consequences of the spinoff. As I discussed in earlier columns, the spinoff plan depends on an aggressive interpretation of the tax code, and the stakes are high. Until now, the board has been willing to brush off concerns about whether the tax plan will work as advertised.

The deal was initially conditioned on receipt of a private letter ruling from the I.R.S., as is customary in many spinoffs. The I.R.S. declined to give Yahoo a private letter ruling that would bless the transaction, signaling a possible break from previous policy. The board marched ahead anyway, leaving in place, as a condition to closing, that Yahoo would receive an opinion from its tax adviser, Skadden, confirming that the deal would be tax-free to the company and its shareholders.

It got worse. In September, the I.R.S. issued an administrative pronouncement, Notice 2015-59, explaining that the “Treasury Department and the Service have become aware, in part through requests for letter rulings,” that certain spinoffs were structured in a way that may violate the tax code. The Treasury and I.R.S. explained that they were “most concerned” about deals that involved a large amount of investment assets (i.e., like Yahoo’s stake in Alibaba). The I.R.S. clarified that it believed that such spinoffs were, “under current law,” less “justifiable” than other transactions.

It doesn’t sound so bad, maybe. But reading an I.R.S. notice is a bit like reading an announcement from the Federal Reserve. The language is dry, but the precise wording tells volumes about future actions.

The I.R.S. follows an unwritten playbook when there are deals in the pipeline, especially when a publicly traded company is involved. If it wants to challenge a deal structure that is becoming popular, waiting to do so in an audit might be an unfair surprise to the company and its shareholders. If it waits to issue regulations, it might have trouble applying the regulations retroactively to deals that have already closed. So instead of going through the formal and time-consuming process of issuing proposed regulations, the I.R.S. issues an administrative notice quickly to make stock market participants aware that the deal structure may not “work.” It then follows up with formal regulations later.

Tax lawyers understand the playbook. They decipher the signals and the administrative notice and, if they can, figure out another way to structure the deal. If the tax consequences are too onerous, the deal may be abandoned altogether.

But in the Yahoo deal, Skadden seems to be ignoring the unwritten playbook. Skadden believes the deal should be tax-free, and it believes that if the case went to court, a judge would side with Yahoo, not the I.R.S. So in October, Skadden reaffirmed its willingness to issue a tax opinion, notwithstanding the I.R.S.’s refusal to issue a private letter ruling, the release of Notice 2015-59 and the significant tax risk to Yahoo and its shareholders.

What makes Skadden’s advice particularly aggressive is the level of confidence it expresses in its opinion that the deal will be tax-free. Skadden has promised a “will” opinion, meaning that in the opinion of Skadden, the transaction will be tax-free to Yahoo and its shareholders (not should be or might be or will probably be, but will be). The opinion is not publicly available, but its conclusion is described to shareholders in securities filings so they can price the deal accordingly. A “will”-level tax opinion is generally thought to convey that the lawyers see almost no tax risk; it is usually taken to mean that there is no reasonable argument to support a contrary conclusion. If Skadden means to depart from this customary usage, then it would have to say so in advance so the board, management and shareholders understand.

There is more lore than law when it comes to tax opinions. There are different levels of confidence. When the lawyers are just a little nervous, the letter might say that “while the matter is not entirely free from doubt,” in its opinion the deal will be tax-free. When the risk is more significant, the firm might write that, in its opinion, the deal “should” be tax-free – reflecting something like a 75 percent level of confidence. An opinion that a deal is “more likely than not” shows a 51 percent level of confidence. There are often more subtle qualifications in the opinion letter as well, which the tax lawyers behind the scenes might describe as a little loose or as having some hair on it. By contrast, a “will” opinion is normally understood as a virtual lock based on well-settled case law, regulations or administrative rulings.

If Skadden follows through with an unqualified will opinion, as it has promised, it would be thumbing its nose at the government. Of course, the lawyers at Skadden know the field better than I do, and reasonable minds might disagree with me (and the I.R.S.) about how to interpret the tax code. It is always possible that a judge will eventually find in Skadden’s favor. But promising Yahoo an unqualified will opinion under these circumstances is, to my knowledge, uncharted territory for in a deal involving a publicly traded company.

Perhaps Skadden is taking a calculated risk. If Skadden is wrong, it’s Yahoo who pays the tax, not Skadden. It might take years for the I.R.S. to successfully challenge the deal in court and even longer to collect a judgment. And given the lack of resources at the I.R.S., the government may be willing to settle with Yahoo for far less than the $10 billion it would be entitled to collect. Yahoo’s management would retain control over the core business for a while longer.

Or it may be that Skadden is playing chicken with the I.R.S., standing fast in public and lobbying behind the scenes to try to salvage the deal.

Whatever Skadden is doing, the stock market is not impressed by its tax bravado. The Yahoo stock price dropped after the I.R.S. announcements, and the price now reflects the tax liability embedded in the Alibaba shares, indicating that market participants believe that the spinoff would not be tax-free as promised.

Skadden may not have even convinced itself. The securities disclosure drafted by Skadden acknowledges that there is a material risk that the tax opinion is wrong. In the words of the securities disclosure, “there is a risk that the I.R.S. may challenge the conclusions reached in the opinion, and a court could sustain such a challenge.” In addition to describing what happens if the plan works, the disclosure also describes the tax consequences of a taxable deal, just in case. The deal also allows Yahoo to shift the entire $10 billion tax risk to Aabaco through an indemnification agreement, just in case. If Yahoo deems a risk to be material and discloses it for securities law purposes, how can Skadden be so confident that the deal “will” be tax-free?

If Skadden follows through and offers Yahoo an unqualified “will” opinion, it would be an inflection point. The elite New York tax bar has traditionally held itself out as part of a profession, not a trade, with intellectual leaders who maintain a healthy cognitive distance from their Wall Street clients. The tax bar may offer sound business advice, but its legal opinions are supposed to be conclusions based on law — as distinct from the realpolitik approach one might get from an accounting firm or investment bank. If a tax opinion is nothing more than a letter from a hired gun, then tax opinions will acquire the same reputation as the fairness opinions issued by investment banks in certain deals.

Steven Davidoff Solomon once described fairness opinions as having a reputation for being “conflict-ridden, subjective, rubber stamps, meaningless and hackneyed.”

The Yahoo board would be wise to avoid this tax mess and sell the core business.

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