The Value of Skadden's Tax Opinion Letter in the Yahoo Alibaba Spinoff Deal

Professor Victor Fleischer's just written Yahoo’s Spinoff Plan Could Be Risky Business for the New York Times. Yahoo is thinking of spinning off its stock in Alibaba as a separate entity, but this could result in huge taxes on the capital gains. Thus (with my boldface in this lengthy excerpt): 

“...the deal was initially conditioned on receipt of a private letter ruling from the I.R.S., as is customary in many spinoffs. The I.R.S. declined to give Yahoo a private letter ruling that would bless the transaction, signaling a possible break from previous policy. The board marched ahead anyway, leaving in place, as a condition to closing, that Yahoo would receive an opinion from its tax adviser, Skadden, confirming that the deal would be tax-free to the company and its shareholders.

It got worse. In September, the I.R.S. issued an administrative pronouncement, Notice 2015-59, explaining that the “Treasury Department and the Service have become aware, in part through requests for letter rulings,” that certain spinoffs were structured in a way that may violate the tax code. The Treasury and I.R.S. explained that they were “most concerned” about deals that involved a large amount of investment assets (i.e., like Yahoo’s stake in Alibaba). The I.R.S. clarified that it believed that such spinoffs were, “under current law,” less “justifiable” than other transactions.  

It doesn’t sound so bad, maybe. But reading an I.R.S. notice is a bit like reading an announcement from the Federal Reserve. The language is dry, but the precise wording tells volumes about future actions.

The I.R.S. follows an unwritten playbook when there are deals in the pipeline, especially when a publicly traded company is involved. If it wants to challenge a deal structure that is becoming popular, waiting to do so in an audit might be an unfair surprise to the company and its shareholders. If it waits to issue regulations, it might have trouble applying the regulations retroactively to deals that have already closed. So instead of going through the formal and time-consuming process of issuing proposed regulations, the I.R.S. issues an administrative notice quickly to make stock market participants aware that the deal structure may not “work.” It then follows up with formal regulations later.

Tax lawyers understand the playbook. They decipher the signals and the administrative notice and, if they can, figure out another way to structure the deal. If the tax consequences are too onerous, the deal may be abandoned altogether.

But in the Yahoo deal, Skadden seems to be ignoring the unwritten playbook. Skadden believes the deal should be tax-free, and it believes that if the case went to court, a judge would side with Yahoo, not the I.R.S. So in October, Skadden reaffirmed its willingness to issue a tax opinion, notwithstanding the I.R.S.’s refusal to issue a private letter ruling, the release of Notice 2015-59 and the significant tax risk to Yahoo and its shareholders.

What makes Skadden’s advice particularly aggressive is the level of confidence it expresses in its opinion that the deal will be tax-free. Skadden has promised a “will” opinion, meaning that in the opinion of Skadden, the transaction will be tax-free to Yahoo and its shareholders (not should be or might be or will probably be, but will be). The opinion is not publicly available, but its conclusion is described to shareholders in securities filings so they can price the deal accordingly. A “will”-level tax opinion is generally thought to convey that the lawyers see almost no tax risk; it is usually taken to mean that there is no reasonable argument to support a contrary conclusion. If Skadden means to depart from this customary usage, then it would have to say so in advance so the board, management and shareholders understand.

There is more lore than law when it comes to tax opinions. There are different levels of confidence. When the lawyers are just a little nervous, the letter might say that “while the matter is not entirely free from doubt,” in its opinion the deal will be tax-free. When the risk is more significant, the firm might write that, in its opinion, the deal “should” be tax-free – reflecting something like a 75 percent level of confidence. An opinion that a deal is “more likely than not” shows a 51 percent level of confidence. There are often more subtle qualifications in the opinion letter as well, which the tax lawyers behind the scenes might describe as a little loose or as having some hair on it. By contrast, a “will” opinion is normally understood as a virtual lock based on well-settled case law, regulations or administrative rulings....

Skadden may not have even convinced itself. The securities disclosure drafted by Skadden acknowledges that there is a material risk that the tax opinion is wrong. In the words of the securities disclosure, “there is a risk that the I.R.S. may challenge the conclusions reached in the opinion, and a court could sustain such a challenge.”

As Professor Fleischer says, “There is more lore than law when it comes to tax opinions,”  so just by reading the regulations one doesn’t have the full picture, or even knowledge of what the IRS does normally. As I see it, when it comes down to hard cash, the question isn’t whether Skadden’s “will” opinion can save Yahoo and its shareholders from paying tax--- it can’t--- but whether it can save them from penalties, including substantial underpayment penalties. If the taxpayer in good faith takes advice from a tax lawyer, he can avoid some penalties. Even a “more likely than not” letter is good enough for that, so Skadden is going overboard here with its “will” letter.

   What I wonder is whether in this situation the “will” letter is actually less protection than a weaker letter would have been. The letter does have to be issued in good faith, and it doesn’t seem like a “will” letter can be issued in good faith by as skillful a lawyer as one who could get a job at Skadden. Yahoo really needs a weaker letter from a worse law firm--- at least if going to a worse law firm weren’t regarded as bad faith in itself.

  On the other hand, Yahoo can  perhaps defend its letter by saying the Skadden lawyer isn’t trying to bluff the IRS, but rather is by a former IRS official or one of his legal-doctrine allies who favored lax spinoff rules  and is using the Yahoo letter as an opportunity to engage in policy battle with the new current IRS official in charge of these things, who favors stricter spinoff rules--- as saying what the law *should* be, and what it *was*,  rather than quite what it *is* currently, if we Chevron-like take IRS interpretations as “the law”.

This is of special interest to me because of my Citigroup suit, where one issue is whether an unreasoned, unreasonable, IRS notice constitutes “authority” that could save Citigroup from penalties even if not from payment of the tax itself.

 Below I've included  long excerpts from the pertinent federal tax regulations. 

“(1) Facts and circumstances; minimum requirements. All facts and circumstances must be taken into account in determining whether a taxpayer has reasonably relied in good faith on advice (including the opinion of a professional tax advisor) as to the treatment of the taxpayer (or any entity, plan, or arrangement) under Federal tax law. For example, the taxpayer's education, sophistication and business experience will be relevant in determining whether the taxpayer's reliance on tax advice was reasonable and made in good faith.

 

...The advice must be based upon all pertinent facts and circumstances and the law as it relates to those facts and circumstances. For example, the advice must take into account the taxpayer's purposes (and the relative weight of such purposes) for entering into a transaction and for structuring a transaction in a particular manner.

...

The advice must not be based on unreasonable factual or legal assumptions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person.”

https://www.law.cornell.edu/cfr/text/26/1.6664-4

“An item of income, gain, loss, deduction or credit is a “tax shelter item” if the item is directly or indirectly attributable to the principal purpose of a tax shelter to avoid or evade Federal income tax.  

...

A taxpayer is considered reasonably to believe that the tax treatment of an item is more likely than not the proper tax treatment if (without taking into account the possibility that a return will not be audited, that an issue will not be raised on audit, or that an issue will be settled)— ...

The taxpayer reasonably relies in good faith on the opinion of a professional tax advisor, if the opinion is based on the tax advisor's analysis of the pertinent facts and authorities in the manner described in paragraph (d)(3)(ii) of this section and unambiguously states that the tax advisor concludes that there is a greater than 50-percent likelihood that the tax treatment of the item will be upheld if challenged by the Internal Revenue Service.”

https://www.law.cornell.edu/cfr/text/26/1.6662-4#g_3

“(3) Determination of whether substantial authority is present

(i) Evaluation of authorities. There is substantial authority for the tax treatment of an item only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment. All authorities relevant to the tax treatment of an item, including the authorities contrary to the treatment, are taken into account in determining whether substantial authority exists. The weight of authorities is determined in light of the pertinent facts and circumstances in the manner prescribed by paragraph (d)(3)(ii) of this section. There may be substantial authority for more than one position with respect to the same item. Because the substantial authority standard is an objective standard, the taxpayer's belief that there is substantial authority for the tax treatment of an item is not relevant in determining whether there is substantial authority for that treatment.

(ii) Nature of analysis. The weight accorded an authority depends on its relevance and persuasiveness, and the type of document providing the authority. For example, a case or revenue ruling having some facts in common with the tax treatment at issue is not particularly relevant if the authority is materially distinguishable on its facts, or is otherwise inapplicable to the tax treatment at issue. An authority that merely states a conclusion ordinarily is less persuasive than one that reaches its conclusion by cogently relating the applicable law to pertinent facts. The weight of an authority from which information has been deleted, such as a private letter ruling, is diminished to the extent that the deleted information may have affected the authority's conclusions. The type of document also must be considered. For example, a revenue ruling is accorded greater weight than a private letter ruling addressing the same issue. An older private letter ruling, technical advice memorandum, general counsel memorandum or action on decision generally must be accorded less weight than a more recent one. Any document described in the preceding sentence that is more than 10 years old generally is accorded very little weight. However, the persuasiveness and relevance of a document, viewed in light of subsequent developments, should be taken into account along with the age of the document. There may be substantial authority for the tax treatment of an item despite the absence of certain types of authority. Thus, a taxpayer may have substantial authority for a position that is supported only by a well-reasoned construction of the applicable statutory provision.

(iii) Types of authority. Except in cases described in paragraph (d)(3)(iv) of this section concerning written determinations, only the following are authority for purposes of determining whether there is substantial authority for the tax treatment of an item: Applicable provisions of the Internal Revenue Code and other statutory provisions; proposed, temporary and final regulations construing such statutes; revenue rulings and revenue procedures; tax treaties and regulations thereunder, and Treasury Department and other official explanations of such treaties; court cases; congressional intent as reflected in committee reports, joint explanatory statements of managers included in conference committee reports, and floor statements made prior to enactment by one of a bill's managers; General Explanations of tax legislation prepared by the Joint Committee on Taxation (the Blue Book); private letter rulings and technical advice memoranda issued after October 31, 1976; actions on decisions and general counsel memoranda issued after March 12, 1981 (as well as general counsel memoranda published in pre-1955 volumes of the Cumulative Bulletin); Internal Revenue Service information or press releases; and notices, announcements and other administrative pronouncements published by the Service in the Internal Revenue Bulletin. Conclusions reached in treatises, legal periodicals, legal opinions or opinions rendered by tax professionals are not authority. The authorities underlying such expressions of opinion where applicable to the facts of a particular case, however, may give rise to substantial authority for the tax treatment of an item. Notwithstanding the preceding list of authorities, an authority does not continue to be an authority to the extent it is overruled or modified, implicitly or explicitly, by a body with the power to overrule or modify the earlier authority. In the case of court decisions, for example, a district court opinion on an issue is not an authority if overruled or reversed by the United States Court of Appeals for such district. However, a Tax Court opinion is not considered to be overruled or modified by a court of appeals to which a taxpayer does not have a right of appeal, unless the Tax Court adopts the holding of the court of appeals. Similarly, a private letter ruling is not authority if revoked or if inconsistent with a subsequent proposed regulation, revenue ruling or other administrative pronouncement published in the Internal Revenue Bulletin.”

https://www.law.cornell.edu/cfr/text/26/1.6662-4#d_3_ii