Friday, October 28, 2011

Yahoo Evaluating Cash-Rich Split Offs

The Wall Street Journal (sub. required) has reported that Yahoo Inc. is considering a disposition of its stakes in Alibaba and Yahoo Japan through cash-rich split offs. Yahoo owns a 43% stake in Alibaba, a Chinese search engine, and a 35% stake in Yahoo Japan.

The split-off transactions would make Yahoo a more attractive target for a subsequent acquisition by a private equity group or strategic investor (e.g., Microsoft). The market has speculated that Yahoo's complicated relationships with Alibaba and, to a lesser extent, Yahoo Japan, have discouraged potential suitors from offering a marriage proposal.

So what is a "split off" transaction? Why does the WSJ article describe the proposal as a "cash-rich split off" transaction? Can the tax lawyers save the day for Yahoo and its beleaguered long-term shareholders?

Spin Offs, Split Offs and Split Ups

Section 355 of the Internal Revenue Code governs "spin off" transactions, "split up" transactions and "split off" transactions.
  • A "spin off" occurs when a distributing corporation (let's call it "Distributing") distributes the stock of a controlled subsidiary (let's call it "Controlled") pro rata to its shareholders. Following a spin-off transaction, the shareholders of Distributing also own stock of Controlled.

  • A "split off" is similar to a "spin off," but with a twist. A "split off" occurs when Distributing redeems shares from one or more shareholders -- but not all shareholders -- in exchange for stock of Controlled. Following a split-off transaction, some of the historic shareholders of Distributing continue to own stock of Distributing. However, other historic shareholders own stock of Controlled. The latter group "trades" its interest in the overall Distributing business for a more direct interest in the Controlled business.

  • In a "split up" transaction, Distributing engages in more than one business, for example, Business A and Business B. Distributing redeems stock from some shareholders in exchange for stock in a corporation that owns Business A. Distributing redeems stock from other shareholders in exchange for a stock in a corporation that owns Business B. Distributing is like the head of the Hydra. Following a split-up transaction, Distributing has disappeared, and its former shareholders go their own separate ways with stock in Corporation A (which owns Business A) and Corporation B (which owns Business B).
Yahoo's proposed dispositions of Alibaba and Yahoo Japan would be structured as "split off" transactions. As noted, Yahoo is a shareholder of Alibaba and Yahoo Japan. If the parties implement the "split off" proposal, Alibaba and Yahoo Japan would be the distributing corporations. Alibaba and Yahoo Japan would redeem their stock currently owned by Yahoo in exchange for stock in a controlled subsidiary. Following the transactions, Yahoo would cease to own any shares in Alibaba and Yahoo Japan. Instead, it would own stock in a corporation formerly owned and controlled by Alibaba and Yahoo Japan, respectively.

To qualify under Section 355, the split-off transactions contemplated by Yahoo must satisfy a number of technical conditions. If those conditions are satisfied, the split-off transactions would be non-taxable to the distributing corporations (Alibaba and Yahoo Japan) and to its shareholders (Yahoo itself). Section 355 thus permits a corporation to "shuffle" the form of its investment in a lower-tier corporation, without triggering income tax on any appreciation in the stock of such corporation.

Cash-Rich Split Offs

Now we're getting to the real action. Yahoo may be able to exchange its stock in Alibaba and Yahoo Japan for stock of a new corporation. But what does that accomplish? The market is already penalizing Yahoo for its unwieldy legal structure, which includes large but non-controlling stakes in Alibaba and Yahoo Japan. Would a split-off transaction address the market's concerns?

For Yahoo's shareholders, I have good news and bad news.

Good News

The good news is that Yahoo could effectively "monetize" its investments in Alibaba and Yahoo Japan through a cash-rich split off. By "monetize," I mean that Yahoo could convert its stock in Alibaba and Yahoo Japan into stock of new corporations whose principal assets are cash or other liquid securities. Although each of the new corporations must be engaged in a historic (five-year) trade or business after the split-off, up to two-thirds of its assets may be composed of cash or other liquid securities.

If the parties implement cash-rich split offs:
  • Immediately before the split offs, Yahoo would own 43% of the stock of Alibaba and 35% of the stock of Yahoo Japan, respectively; and

  • Immediately after the split offs, Yahoo would own 100% of stock of two new corporations. The first corporation would have a historic (five-year) trade or business formerly conducted by Alibaba, and a bucket of cash or other liquid securities. The second corporation would have a historic (five-year) trade or business formerly conducted by Yahoo Japan, and a bucket of cash or other liquid securities.

  • Then Yahoo's shareholders and its pointed-headed tax lawyers would pop some champagne and haul out their dancing shoes. Well, maybe the shareholders would haul out their dancing shoes.
You might be curious whether Alibaba and Yahoo Japan could simply redeem Yahoo's shares for cash. Why does Yahoo need an army of pointed-headed tax lawyers to monetize its investments in Alibaba and Yahoo Japan? Alas, life is not so simple under current U.S. tax rules. The redemption transaction (exchange of stock for cash) would be taxable to Yahoo. Yahoo would incur U.S. tax expense and its after-tax cash proceeds would take a corresponding haircut. So bring on the tax lawyers!

Bad News

Now for the bad news. Unlike a corporation that owns 100% of a business, Yahoo owns a large, non-controlling stake in Alibaba and Yahoo Japan. Yahoo would require cooperation of the boards of directors of each company to implement a cash-rich split off transaction. Each board (including Yahoo's) would have a fiduciary duty to ensure a "value for value" exchange. It might be very difficult to negotiate a valuation that makes everybody happy. That said, if the tax savings to Yahoo were sufficiently material, Yahoo may be able to "share" some of that savings with Alibaba or Yahoo Japan to bridge any gaps in the numbers.

The parties would be required to navigate the various conditions of Section 355. For the most part, those should be manageable. The biggest hurdle would probably be Section 355(g), which was enacted in 2006 to diminish the appeal of cash-rich split offs. Section 355(g) limits the "investment assets" of a controlled corporation to two-thirds of the fair market value of all its assets. For such purposes, "investment assets" include cash and other liquid securities. To comply with the limitations of Section 355(g) any cash-rich split off would need to include material business assets of Alibaba and Yahoo Japan, respectively.

Finally, Alibaba and Yahoo Japan would need to "stuff" the controlled corporation with cash or liquid securities. Such an effort may require external financing, which may or may not be palatable to the directors of Alibaba and Yahoo Japan. The tax tail is not going to wag the dog unless the parties can round up financing to make the cash-rich split off work.


Another hurdle for Yahoo would involve the repatriation of cash from its new subsidiary companies. Although I can only speculate on the transaction form, Yahoo is likely to own stock in a new foreign subsidiary following a split off from Alibaba or Yahoo Japan. As described above, the foreign subsidiary would have a historic (five-year) trade or business, and a large amount of cash and liquid securities.

If Yahoo repatriates the cash by causing its new subsidiary to pay a dividend, the dividend could be taxable to the U.S. group. Yahoo may or may not have sufficient foreign tax credits to offset the resulting U.S. tax liability. Any limits on repatriation may reduce the attractiveness of the split-off idea.

Alternatively, after the dust has settled on the split-off, Yahoo may be able to liquidate the foreign subsidiary and repatriate cash in the liquidation transaction. Such a liquidation would also be taxable to the extent of the foreign subsidiary's earnings and profits.

In either case, a portion of the distributing corporation's earnings and profits would be allocable to the controlled corporation immediately before the tax-free split off. Under the mechanical allocation rules, the new corporation may inherit a very small earnings pool from Alibaba or Yahoo Japan, respectively. If the earnings pool is small, a liquidation transaction may be a viable repatriation option for Yahoo. In any case, tax nerds and Yahoo shareholders will stay tuned for developments in the Yahoo story.

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For more on cash-tax split offs, two articles by the ubiquitous Robert Willens are worth a read. See "Liberty Media and News Corp. Will Be Parting Ways," 114 Tax Notes 697 (Feb. 12, 2007), and "Can STI Efficiently 'Monetize' Its KO Stake," 120 Tax Notes 601 (Aug. 11, 2008). He even mentions Yahoo! in this interview (published Saturday, October 22).


  1. Excellent post. Thanks so much for sharing.

  2. Thanks for the feedback. Glad you found the post worth a read. KM

  3. Very informative and well written. Thanks for taking the time to explain this issue.

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