Yahoo spinoff poses more questions than answers
INSIGHT ARTICLE |
Yahoo, Inc. (Yahoo) recently announced that it will divest its approximate $40 billion stake in Alibaba Group Holding Ltd (Alibaba)-along with a "legacy, ancillary operating business" through a proposed tax free spinoff under section 355. This transaction appears to end the speculation on how Yahoo will return the Alibaba value to its shareholders in a tax efficient manner. However, there are a number of key questions that still remain unanswered as part of this transaction.
Background of Yahoo's ownership in Alibaba
Due to Chinese legal restrictions on foreign ownership in telecommunications services, Alibaba is a complex organizational structure that consists of various contractual arrangements, variable interest entities, and other agreements in lieu of direct ownership in corporate subsidiaries. The traded "shares" of Alibaba are actually American depository shares (ADS). Each ADS represents one ordinary share in Alibaba Group Holding Ltd, a company registered in the Cayman Islands with principal executive offices in China.
On Sept. 24, 2014, Yahoo sold 140 million Alibaba shares at $68/share in the initial public offering (IPO) of Alibaba through its Hong Kong subsidiary. This resulted in pretax proceeds of $9.4 billion on which Yahoo anticipates paying tax of approximately $3.3 billion. Yahoo currently holds 384 million Alibaba shares that have a pretax value of roughly $40 billion, as well as built-in gains of about $38.9 billion. After Yahoo sold the first 140 million Alibaba shares in a taxable transaction, Yahoo's shareholders urged it to develop a tax efficient strategy for the divestiture of the remaining shares. In a public presentation on Jan. 27, 2015, Yahoo announced a proposal for a tax-free spinoff under section 355 of the interest in Alibaba, along with a legacy, ancillary operating business.
Yahoo will contribute 100 percent of its remaining stake in Alibaba plus a legacy, ancillary, operating business of Yahoo, to SpinCo. The shares of SpinCo will be distributed to Yahoo's shareholders pro-rata. SpinCo will be an independent publicly traded company and will also be an "investment company" registered under the Investment Company Act of 1940. SpinCo will assume no debt as part of the transaction and Yahoo will retain cash.
The transaction is expected to be completed in the fourth quarter of 2015 subject to certain closing conditions, including:
- Final approval from Yahoo board of directors
- A private letter ruling (PLR) from the IRS regarding certain aspects of the transaction
- A favorable legal opinion regarding the tax-free status of the spinoff
- Filing and registration with the SEC and compliance with the Investment Company Act of 1940
Observations of the proposed transaction
The spinoff itself will remove the shares of Alibaba from Yahoo without triggering income tax. However, this transaction does not, by itself, return the value of the Alibaba shares to the shareholders. Rather, it moves the shares to a different corporation. In order to extract the value of the underlying investment from SpinCo, there must be a second step. The current thinking is that Alibaba may look to acquire SpinCo. The logic behind such an acquisition is that SpinCo has now become an investment vehicle for the public market to access Alibaba without actually purchasing Alibaba stock. This would fragment the market and potentially divert investment away from Alibaba and to SpinCo (e.g., if SpinCo trades at a discount compared to Alibaba, then investors may be inclined to invest in SpinCo compared to direct investment into Alibaba). This gives Alibaba incentive to buy back its shares and acquire SpinCo.
However, if Alibaba were to acquire the stock of SpinCo, it would then find itself in a sandwich structure with a U.S. company between two foreign companies, likely creating tax inefficiencies with dividends and profit repatriation. It may be possible to migrate SpinCo from a U.S. to a foreign company; however, this would need to be closely scrutinized under the inversion rules of section 7874 and Notice 2014-52 (which addressed so-called "spinversions"). Additionally, this idea jumps to the conclusion that such a transaction first avoids the pitfalls of the device test and the Anti- Morris Trust rule - discussed below.
The device test of section 355(a)(1)(B)
To qualify under section 355, a distribution cannot be used "principally as a device for the distribution of the earnings and profits of the distributing corporation or the controlled corporation or both."1 Failing the device test would result in the spinoff being taxable at both the distributing company level and the shareholder level.
The proposed transaction is to distribute SpinCo on a pro-rata basis. Under the regulations, there are a number of factors that provide guidance as to whether a spinoff is a device:
- "the fact that a distribution is pro rata or substantially pro rata is evidence of device."2
- "sale or exchange of stock of the distributing or the controlled corporation….is [also] evidence of device."3
- "the determination of whether a transaction was used principally as a device will take into account the nature, kind, amount, and use of the assets."4
- "existence of assets that are not used in a trade or business that satisfies the requirements of section 355(b) is evidence of device…include but are not limited to, cash and other liquid assets that are not related to the reasonable needs of a business satisfying such section."5
In all likelihood, the ancillary trade or business that will be transferred to SpinCo will pale in comparison to the relative value of the Alibaba shares. Additionally, since the shares are liquid assets and (presumably) not related to the business needs of the ancillary trade or business, it would appear that the Alibaba stock would fall under the last bullet point. However, non-device factors are also present in the transaction. For example, this spinoff will presumably increase the stock price for both Yahoo and SpinCo. The higher value stock can be used to enhance equity / stock-based compensation programs or effect future acquisitions. Such reasons have been acknowledged by the IRS as having a substantial corporate business purpose for a spinoff.6 The key factor may be the business purpose of the transaction. Such a purpose must be real, substantial, and germane to the business of the corporation.
The anti-morris trust rule of section 355(e)
A distribution of stock in SpinCo is generally taxable at the level of the distributing corporation if the spinoff "is part of a plan (or series of related transaction) pursuant to which one or more persons acquire, directly or indirectly, stock representing a 50 percent or greater interest in the distributing corporation or any controlled corporation."7 The key components for this rule to apply are:
- A majority interest in SpinCo must be acquired subsequent to the spinoff
- The spinoff and subsequent acquisition must be part of a plan
A safe harbor rule applies in the absence of "an agreement, understanding, arrangement, or substantial negotiations regarding the acquisition or a similar acquisition at some time during the two-year period ending on the date of the distribution."8 Thus, absent evidence of a pre-negotiated plan, the section 355(e) rules are not compromised and the distribution is not taxable at the corporate level.
As discussed above, there is speculation that Alibaba may acquire SpinCo. If this occurs, it will be necessary to address the anti-morris trust rules to ensure that the spinoff and subsequent business combination by Alibaba are not part of a plan or series of related transactions. If they are viewed as such, then gain could be triggered to Yahoo under section 355(e). The safe harbor rule is important in this respect. Absent evidence of a pre-negotiated/planned transaction between Yahoo and Alibaba, then the transactions would avoid section 355(e). However, given the high profile nature of this transaction and the speculation in the marketplace, this facet will likely be tested.
The key takeaway is that neither Yahoo nor SpinCo are out of the woods quite yet. Given that the proposed transaction is conditioned on a favorable PLR, practitioners can expect an intimate look at the transaction details. Assuming the spinoff meets the statutory requirements, the next (and arguably more interesting) component is how SpinCo fares on the open market and whether Alibaba will acquire the company. If Alibaba does acquire the company, how it would deal with the potential sandwich structure remains to be seen.
 Section 355(a)(1)(B)
 Reg. section 1.355-2(d)(2)(ii)
 Reg. section 1.355-2(d)(2)(iii)(A)
 Reg. section 1.355-2(d)(2)(iv)(A)
 Reg. section 1.355-2(d)(2)(iv)(B)
 Rev. Rul. 2004-23
 Section 355(e)(2)(A)
 Reg. section 1.355-7(b)(2)