Why Yahoo decided not to spin off Alibaba

Yahoo CEO Marissa Mayer said Wednesday the company made a prudent decision to abandon plans to spin off its 384 million-share stake in the Chinese e-commerce giant Alibaba amid tax concerns.

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"Overall, we did see indication, certainly in the market, around tax uncertainty and the duration of time it might take to get to resolution. Given that, we feel it's prudent at this time to look at alternatives like the reverse spin," Mayer told CNBC's "Squawk on the Street."

In January, Yahoo planned on using the new public holding company, Aabaco, as a vehicle to distribute shares of Alibaba to shareholders. This spinoff was intended to avoid incurring a capital gains tax on the divestiture. Shareholders would also forgo paying a second dividend distribution tax of about 15 percent on those shares.

However, the Internal Revenue Service essentially put a stop to this plan, later telling Yahoo that it would not rule on whether the structure of the deal would qualify as a tax-free spinoff.

Maynard Webb, chairman of Yahoo's board of directors, said he believed the Aabaco spinoff would be tax free, but still the board ultimately came to see that the risk of the IRS's intervening in the process is too great. For companies like Yahoo that are taxed at the top corporate rate of 35 percent, the capital gains tax for the stock would amount to about $10 billion if Yahoo sold Alibaba shares outright.

"Among other factors, we were concerned about the market's perception of tax risk, which would have impaired the value of Aabaco stock until resolved," Webb said in a statement.

The deliberations by the Yahoo board were also taking place under the pressure of Starboard Value, an activist hedge fund, who argued that the company should sell its core advertising business and leave its ownership stakes in Alibaba and Yahoo Japan in the existing corporate entity.

"If you stay on the current path, we believe the potential penalty for being wrong is just too great, and the potential reward for being right is not materially better than the other alternative. When compared to a sale of the Core Business, there is minimal reward in relation to the massive potential risk that you could be taking," said Starboard in a letter to Yahoo.

While Yahoo would still have to pay taxes in a "reverse spinoff" of Yahoo's search and display core business, Starboard noted that pursuing an Alibaba spinoff would be much more costly to shareholders. The reverse spinoff would be less of a financial liability as it would cost about $1 billion to $2 billion, according to Robert Peck, managing director of Internet equity research at SunTrust Robinson Humphrey.

"The big changes for Yahoo were the comments made by the IRS and the fact that they did not receive a PLR blessing the transaction as tax-free," said Peck. "Once they realized they were not going to get that, Yahoo probably figured the possibility of getting taxed would not be tolerable for shareholders."

In this case, a PLR is a private letter ruling or written statement the IRS issues noting that a proposed spinoff is tax free. Since the IRS would not rule on Yahoo's request, the Alibaba transaction could still occur, but it would be considered taxable by the IRS.

"I think what Yahoo did was positive," Peck said. "Many companies would have put in so much work, time, effort and money pursuing the Alibaba spinoff. Yahoo was able to adapt to the IRS' decision, which is a testament to its board. It goes to show they are fulfilling their fiduciary responsibility."