Yahoo Spinoff of Alibaba Sheds Light on Problems with the Corporate Tax System

September 11, 2015

Earlier this week, news broke that the IRS had refused to rule on a proposal by Yahoo! Inc. to spin off its holdings in Alibaba, tax-free. While the details of Yahoo’s proposal and the IRS’s response are complicated, the entire episode points to several fundamental problems with the U.S. corporate income tax and its enforcement.

Yahoo was founded in 1994 as a web directory, and became a major web search engine throughout the next decade. In 2005, Yahoo announced that it would invest $1 billion in Alibaba, a Chinese online marketplace company, giving Yahoo a significant stake in Alibaba. Over the next decade, as the value of Yahoo’s core business steadily declined, its holdings in Alibaba increased greatly in value, rising to almost $40 billion.

But although Yahoo owned $40 billion in shares of Alibaba, it faced up to $16 billion dollars in federal corporate taxes if it ever decided to sell the shares, as the capital gains of corporations are taxed at the top corporate rate of 35 percent. Additionally, if Yahoo distributed the gains from the sale of Alibaba to its shareholders, these gains would be taxed again at the shareholder level, at rates up to 23.8 percent. Overall, if Yahoo decided to sell Alibaba outright, its shareholders would only have received roughly half of Alibaba’s value, due to federal corporate-level and shareholder-level taxes.

Last January, Yahoo announced plans to spin off its stake in Alibaba to its shareholders. In a spinoff, a corporation essentially splits its business in two: it sells part of its business to a newly created corporation and then distributes all of the shares of the new corporation to its shareholders.

Because a spinoff creates profits for the corporation (from selling part of its business) and for shareholders (from the shares they receive), it would normally be taxed at both the corporate level and the shareholder level, as described above. But Yahoo was hoping to rely on section 355 of the federal tax code, which allows corporations that meet certain requirements to split their businesses in two without paying any federal taxes.

In theory, section 355 makes a great deal of sense. When a corporation splits in two, no additional economic revenues are made and no cash is exchanged – so it stands to reason that no additional taxes should be incurred. However, there are a number of restrictions that limit which corporate spinoffs qualify for tax exemption under section 355. Many of these restrictions are fairly vague and quite complicated – over at Forbes, Tony Nitti has an excellent explanation of the technical requirements Yahoo would need to meet to spin off Alibaba tax-free.

Some of the restrictions of section 355 were so vague that Yahoo was not entirely sure whether its spinoff of Alibaba would be taxed or not. So, Yahoo reached out to the IRS for a “private letter ruling,” a binding decision from the IRS about whether its spinoff would be taxable. However, earlier this week, news broke that the IRS decided not to issue a decision at all about the proposed spinoff, leaving Yahoo uncertain as to whether spinning off Alibaba will be worth it at all, given the unclear tax consequences.

Looking broadly at Yahoo’s ongoing adventure with U.S. tax law, it is clear that the company faced three major obstacles to trying to split its business in two. First, under regular corporate tax laws, Yahoo’s sale of Alibaba would have faced two separate levels of taxation, leading to an exceptionally high tax burden. Second, although Yahoo hoped to rely on section 355 to exempt its spinoff from taxes, the vague restrictions in that section created significant business uncertainty for Yahoo and its shareholders. And, finally, the IRS’s refusal to give Yahoo a clear indication of whether the spinoff would be subject to taxes has thrown the entire effort into limbo.

These three obstacles – double taxation, legal complexity, and regulatory uncertainty – are present in many areas of corporate tax law, not just Yahoo’s spinoff of Alibaba. And all three significantly hinder American business operations, slowing down economic growth. The ongoing saga of Yahoo is one more example of why fixing the corporate tax code must be a priority of the federal government.


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