Sep 30, 2015 ยท 5 minutes

No, really, that was the message between the lines of legalese in an SEC filing Yahoo made this week. Hang in there, things could be worse!

Yahoo, of course is the Sunnyvale, Calif.,-based mutual fund that focuses on Asian technology assets, namely shares of Alibaba and Yahoo Japan, and that has a struggling side business of selling ads on email, search and fantasy sports. It also has aspirations of being a big player in mobile and – oh I'm sorry, I forgot for a second there that this is a story about how shareholders view Yahoo.

From a shareholder perspective, Yahoo is an entity charged with disposing of its Alibaba shares a) without having to pay a dollar in taxes and b) before Alibaba's share price stumbles much further. This is a heavy responsibility, and Yahoo takes it seriously.

In January, Alibaba unveiled its plan to arrange a tax-free spin-off of Yahoo's remaining stake in Alibaba, an investment that Jerry Yang procured way back in 2006. To do this, Yahoo arranged to set up a new, independent, publicly traded company it will call Aabaco, with all of the shares then distributed to Yahoo shareholders.

Aabaco would largely track Alibaba's stock, but it would give Yahoo shareholders ownership of what amounts to 15 percent of Alibaba, without having to worry about the challenges facing Yahoo. It was a sound enough plan, leaving Yahoo shareholders confident that all they needed to do was wait until the IRS gave its blessing on the tax-free spinoff, which it had often done on similar deals

Since then, however, a couple of things have messed with the plan. The first is that Alibaba's stock has fallen 38 percent from its first day of trading and dropped 52 percent from its record high of $120 a share last November, thanks to a slowdown in China's economy and transparency issues at the company.

Similarly, Yahoo's stake in Alibaba has fallen from a peak value of $46 billion last fall to $22 billion today. And if you want to know just how important that stake is to Yahoo shareholders, compare Yahoo's stock chart to Alibaba's since the Alibaba IPO. When Alibaba rose, Yahoo rose. When Alibaba fell, Yahoo fell. The two have been in near lockstep since May.

In February, Yahoo asked the Internal Revenue Service to rule that Aabaco's structure would qualify as a tax-free spinoff. The IRS won't allow spinoffs to be tax free unless they have an active trade or business, so Yahoo included what it called “a legacy, ancillary Yahoo business.” That is, a division it didn't want any more, but that would by virtue of a technicality make Aabaco an active business and just not a bundle of Alibaba shares.

A quick side note here to small businesses that are paying Yahoo money. The legacy, ancillary business Yahoo sacrificed to Aabaco was Yahoo Small Business, which will be renamed Luminate. This tells you exactly how much the company values your business: so little that it would gladly lop it off to plug a tax loophole. You may want to shop around for another web services provider.

Yahoo's well-made plans for a tax-free spinoff hit a snag in May, when the IRS said it was “thinking about” changing its rules for spinoffs to eliminate the very technicality Aabaco was relying on. Earlier this month, Yahoo said the IRS declined to grant the tax-free ruling it had requested. The expected tax rate is between 35 percent or 40 percent, which could reduce the payout to around $14 billion if the spinoff were ruled taxable.

But, and here we finally get to some of the good news, things could be worse. “At the same time,” Yahoo said in a filing, “the IRS indicated that it had not concluded that the proposed spin-off transaction was taxable and therefore was not ruling adversely on the request.” The IRS wasn't ruling Aabaco would be tax free. But it also didn't rule that it would be taxed either. 

Last week, an IRS official offered another ray of hope for Aabaco. The agency is still considering changing the rules, but any change wouldn't apply retroactively to deals completed before it was issued. Yahoo's board met and agreed to go ahead with the spinoff, knowing it may not be tax free. Yahoo's plan now seems to be to move ahead quickly, hoping to be grandfathered into the new guidelines.

Most analysts think the spinoff has at 50/50 chance or better of being tax free. Yahoo's stock rallied as much as 6 percent Tuesday on the news. But the move could also leave Yahoo with a huge headache. As Rob Sanderson at MKM Partners said,

This decision could potentially put shareholders on the hook for any tax liability should the IRS challenge YHOO’s interpretation of tax treatment in the future. We expect this would trigger a legal battle.

And then there is the elephant in Yahoo's HQ, which is the state of operations that will remain after a spinoff is done. Last quarter, Yahoo's revenue ex-TAC (or traffic acquisition costs) was flat at $1.04 billion and the company posted an operating loss of $45 million. Worse, its free cash flow – a measure of how well the core business is making money – was negative $25 million.

Remember, this is three full years into Marissa Mayer's effort to turn Yahoo around. Re/code recently reported that several top executives are leaving the company, some of them “apparently exasperated by the lack of progress in its turnaround.”

“There is so little good news coming from Yahoo these days that it appears to feel that it must complete the spin-off of Alibaba to shareholders, even if it results in a big tax bill for investors,” said Edison Investment Research analyst Richard Windsor in a research note. “To me, this is an indication that there continues to be no progress on the turnaround and therefore substantial pressure to deliver something.”

The silliest thing about this campaign is that Mayer, hired by Yahoo to turn it around, has been distracted by a less noble task: helping shareholders to erect a complex tax dodge. The $9 billion or so in taxes from a sale of Alibaba shares would go to the U.S. Treasury, just as the law intended. It might be best for Mayer to just pay it so she can focus entirely on fixing Yahoo. Assuming it's not too late to do that.


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