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Here's the doomsday scenario where Yahoo loses money spinning off its stake in Alibaba

Myles Udland   

Here's the doomsday scenario where Yahoo loses money spinning off its stake in Alibaba
Tech4 min read

Marissa Mayer

AP

Yahoo CEO Marissa Mayer.

Yahoo's stake in Alibaba is turning into a headache.

In a note to clients on Wednesday, analyst Bob Peck at SunTrust examines a scenario in which Yahoo's tax bill for spinning off its stake in Alibaba - which at one point was assumed to be 0% - could be more than 100%.

To quickly review, back in January Yahoo announced it would spin-off its remaining 15% stake in Alibaba in a transaction scheduled to be completed during the fourth quarter of this year.

In this new SpinCo, Yahoo will include its Yahoo Small Business unit to meet the requirement that Yahoo have some actual business in the new unit. But so the question is whether that unit actually meets IRS standards.

As the IRS' Isaac Zimbalist said at an event in May, "The issue comes down to whether we've dropped a hot dog stand or a lemonade stand into a business that is primarily publicly traded stocks, cash, and other wonderful things that I call appreciated property."

Zimbalist was not referring to Yahoo specifically but about the general idea of companies spinning off assets into a separate unit without any tax consequences.

As Peck writes, the question is whether the IRS deems Yahoo's Alibaba SpinCo, which will be called Aabaco, meets the IRS', "Section 355's requirements where business purposes outweigh any concerns on whether it is primarily a 'device' to transfer gains."

That is, you can't just re-shuffle assets in tax-advantaged ways unless there is a business reason to do so. Peck thinks it's likely that Yahoo does meet this criteria. However! There is a chance this goes very wrong.

Here's Peck (emphasis added):

As we pointed out in our previous note, we think that if the IRS were to ultimately tax the spin transaction, that not only would Aabaco need to indemnify Yahoo and pay the taxes, but that the indemnification payment itself would likely be taxable. This would equate to ~50% of Aabaco's value. However, to pay the indemnification, Aabaco would likely need to sell shares of Alibaba which we believe could be taxable on a non- stepped up cost basis (taking the tax hit to ~70%). Further, shareholders could also have a tax bill, as the spin may be a "quasi dividend," taking the tax bill to ~100%. Finally, China could elect to follow the US move and tax it at 10%. Together, these taxes would usurp >100% of Aabaco's value.

So in short, Yahoo and its shareholders could be face taxes on the sale of Alibaba shares that are sold in order to pay required taxes on the original spin-off. Additionally, in this doomsday scenario, shareholders could pay taxes in China, too.

Now again, Peck is bullish that Yahoo's tax plan will go off without a hitch, assigning a greater than 90% likelihood that this will ultimately be the case.

But in addition to the scenario in which Yahoo is taxed on transactions that are required in order to pay other taxes, the thing that could really be a drag for shareholders is how long this all might take.

Peck again:

Since Yahoo shrewdly deferred the spin-off to January 2016, the company will be required to include the transaction under its 2016 tax return that will be due October 2017; the IRS then has three years to decide whether or not it wants to select the case for audit ... If Yahoo files in October 2017, then the IRS has until October 2020 to decide. Procedurally, the worst-case scenario will be if the IRS picks up the case for audit in October 2020, decides to impose taxes, and the company has to go through the protracted legal process before the issue is finally decided. In this case, it is possible that Aabaco shareholders may not have clarity on the tax question for the better part of the next decade.

Where will the company be at that point? Who knows, really.

As Peck wrote last week, this could be the time for the company to consider a new CEO, and a recent report from Kara Swisher said that Yahoo has hired McKinsey to look at the company's organization.

And then it seems that in at least in one scenario the main value proposition offered by Yahoo right now - its stake in Alibaba - could be in limbo for the next several years.

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