Developments from Altaba’s Trial—Judge Indicates Path Likely for Second Interim Distribution

By Stuart E. Leblang, Michael J. Kliegman and Amy S. Elliott

April 22 was the final day of the three-day trial of the court-supervised Delaware General Corporation Law Section 280 dissolution of Altaba Inc. (trades over-the-counter as 021ESC017) (Altaba).  It was on the final day of trial that Delaware Court of Chancery Judge J. Travis Laster told counsel for Altaba that he had thought more about the company’s plans to renew its request for a second interim order at the close of trial.

(Recall that on April 15, Altaba submitted a motion and proposed order asking the court to reduce the total interim holdback from its current approximate $8.14 billion down to about $5.08 billion and to authorize Altaba’s Board of Directors to make additional distributions to shareholders of as much as $2.88 billion (or $5.55 per share). ¹  The motion was denied.)

In his comments April 22, Judge Laster seemed to indicate that, upon hearing all of the evidence at trial, he now may not think there needs to be “an expansively higher reserve for the unknown claims.” But, rather than have Altaba refile the exact same order, he said he would prefer if the company “file a motion and submit a proposed order that seeks resolution on all of the issues other than the matters that are actively disputed.  That, to me, is a more efficient path than piecemeal-ing it.”

Judge Laster later clarified that he would prefer for Altaba to rework the motion and related order so that they comply with Rule 54(b) of the Federal Rules of Civil Procedure.  Upon granting the order, which would be detailed enough to set forth the specific reserve amounts for particular items, the judge would be rendering a partial final judgment, saving himself time on the ultimate opinion addressing the three buckets of disputed items (involving Droplets, Inc., Verizon Communications Inc. ² (Verizon) and Emily Larocque).

This may mean that Judge Laster will be willing to grant Altaba authority to make a second interim distribution in short order (not waiting until the final opinion).  The final opinion/order on the Section 280 petition in this case ³ is not expected until this summer, as the judge has 90 days to issue a ruling, and the 90-day period restarts for certain post-trial activities (including the oral argument on Larocque’s claims, which is not scheduled until May 28, 2021).

Further, while Judge Laster indicated that he only wants the partial final order to address non-disputed issues, the thinking is that this means not all Droplets/Verizon/Larocque amounts are off the table for a reduction.  Specifically, because all of the reductions sought in the second interim distribution order from April 15 involved undisputed amounts (for example, the voluntary reduction of a demanded holdback by Verizon for its tax-related indemnity claims from $3,161.8 million to $925,430,000), it is thought that the amounts requested this time around will not change. ⁴ While we could be misinterpreting the judge’s instructions, this could very well be good news for shareholders.

Aside from that distribution development on day three, day two uncovered some interesting tax nuggets during witness testimony from Altaba and Verizon debating the need for additional tax holdback.  (Day one largely involved the Droplets dispute, which was closed to public access.)

The public line was not connected to the April 21 proceedings until just before 9:50 a.m., meaning that interested investors missed the start of live testimony by fact witness Altaba Chief Financial and Accounting Officer Alexi Wellman.  But numerous details were revealed about the status of the Internal Revenue Service (IRS) audit of Altaba’s 2016 and 2017 federal income tax returns (2016/2017).  Namely:

• In an April 20 biweekly call with the IRS, it was communicated to Altaba and Verizon that the IRS is on schedule to wrap up its fieldwork and issue all outstanding Notices of Proposed Adjustment (NOPAs) for 2016/2017 by the end of April. ⁵ 
• The IRS expects to issue a Revenue Agent’s Report (RAR)—marking the conclusion of the IRS examination—for 2016/2017 by the end of May, at which point it is expected that Altaba will sign an IRS Form 870 ⁶ agreeing to the assessment, pay whatever additional taxes the IRS deems are owed and will then (potentially) file suit in federal court to seek refunds for any amounts that Altaba thinks were inappropriately assessed.
• The statute of limitations for 2016/2017 does not expire until October 15, 2021 (and Altaba has declined to agree to the IRS’s request for a statute extension). Verizon indicated it would consider releasing some of its holdback sooner than October 2021 if the scenario described above were to play out, although it would still be concerned about the correlative state tax implications of such a federal income tax assessment.

‘A Matter of Months’

The tax-related indemnification dispute between Altaba and Verizon has grown considerably smaller in recent weeks.  On October 19, 2020, Judge Laster ordered Altaba to set aside $3.162 billion for Verizon’s tax claims, as Altaba had agreed to indemnify Verizon for certain taxes (through 2017) for which Verizon is severally liable. ⁷  Verizon’s latest ask—an amount that is expected to be further reduced ⁸ —is only about $925 million.  It arguably could be reduced significantly in just a matter of months, assuming the optimistic outline of events detailed above comes to fruition.

Verizon’s argument is that even though Altaba established a $1.767 billion reserve to cover its possible federal tax liabilities (as set forth in the August 2020 IRS-Altaba Agreement), given that the 2016/2017 audit is ongoing and the reserve is not segregated by year, there is no guarantee that such a reserve will be sufficient to cover IRS claims for which Verizon is severally liable.

Specifically, Verizon believes there is still a risk that Altaba will not be able to substantiate all of the tax basis claimed in the assets Yahoo! Inc. (Altaba’s predecessor) sold to Verizon.  It made an Internal Revenue Code (IRC) Section 338(h)(10) election to recharacterize its sale of stock—the sale of Yahoo’s operating business to Verizon—as a sale of assets.

“Until the audit closes, until fieldwork is completed, if the IRS becomes aware of new information, they can still make adjustments.  It doesn’t have to be a new issue.  It can even be an issue that they’ve already ostensibly looked at.  They still have the authority to make adjustments,” said William Van Saders, the Senior Vice President and Deputy General Counsel of Corporate Taxes at Verizon in live testimony April 21.  “So we think there’s still a risk.”

Van Saders then proceeded to apparently flag possibly new (to the IRS) information on a separate, but related issue.  In connection with the same transaction, Yahoo apparently sold stock of Tumblr, Flurry and BrightRoll (excluding those stock sales from the Section 338(h)(10) election).  “We are aware of certain specific basis adjustments that the IRS hasn’t looked at, and if they became aware of them, we felt that there would be a greater risk of an adjustment, and that’s why we used the higher risk factor for that,” Van Saders said.  It appears that the basis adjustments for which Van Saders provided a discounted risk assessment (this and two others, including the Section 338(h)(10) item described above) could result in nearly $120 million in additional taxes owed, if the IRS takes his view of the risk.

But Van Saders explained that Verizon decided to apply its highest risk assessment to an issue it referred to as the deemed-paid deduction.  This appears to involve what the IRS originally thought would cause a $9 million increase to Altaba’s income for 2017. ⁹  Verizon thinks the IRS may entirely disallow deductions claimed on Altaba’s 2017 return related to liabilities that Verizon assumed as part of the 2017 sale of Yahoo’s core assets.

“We assumed initially that Altaba could not substantiate that these deductions were properly claimed in the 2017 tax year.  Because this is one of the most contentious issues on the audit, and because we still haven’t gotten any NOPAs related to this issue, we . . . assumed that it’s still the full amount of the disallowance,” Van Saders said.

So, while Altaba takes the position that Verizon isn’t “analyzing the components of the IRS’s claims and explaining why” the IRS reserve is insufficient, ¹⁰ Van Saders—more than any other witness who testified Wednesday—actually addressed the substance of some of the underlying tax issues.  Many of the tax issue estimates that Verizon uses to calculate its $925 million holdback request come from NOPAs issued by the IRS (there have been 13 NOPAs issued as part of the 2016/2017 audit to date, including one on deferred revenue and one on transfer pricing, “all of which have been agreed to and signed by Altaba” ¹¹ ).

As for making a persuasive case for why a separate holdback is necessary, Van Saders continued to press the argument that the claim amounts used to derive the $1.767 billion reserve as set forth in the August 2020 IRS-Altaba Agreement do not function as caps.  The IRS-Altaba Agreement specifically contemplates that the reserve could effectively be increased by adjustments for items not identified in the Third Revised Claims (the IRS’s claims underlying the $1.767 billion reserve).  And any discussions that the IRS has been having with Altaba indicating that it expects not to raise additional issues are not legally binding.

“We wanted to propose that they segregate the amount of the IRS claim by tax year, so we would know that there were amounts that were segregated for the years for which we could have several liability rather than an open-ended pool that could be depleted,” Van Saders said.  Because sizable taxable transactions occurred in 2018 and 2019, if the IRS were to make significant adjustments with respect to those transactions, it could easily eat through the $1.767 billion reserve, he said.

Van Saders insisted that Verizon’s tax-related indemnification claim is not divorced from reality.  “We think our claims and our concerns are legitimate and real.  We spent a lot of time negotiating the allocation of taxes and the tax indemnity with Altaba, and we expect Altaba to honor its obligations,” Van Saders said.  “Altaba shouldn’t be able to shift the risk of its tax obligations to Verizon just because it decided to dissolve.  And we think that this risk is real.” He added that if everything proves out as Altaba suggests and the 2016/2017 taxes are resolved in the next couple of months, “then holding back the amounts that Verizon is asking to protect its interest should impose no real risk on Altaba and its shareholders.”

But Wellman disagreed, insisting that the additional holdback is harmful.  The IRS already pulled every material item, she said.  “What they have left to even identify is insignificant.  I feel like our cushion that we already have in the holdback is more than enough,” she said.  Why not wait six months?  “There is a cost.  As I said, we have an obligation to both the creditors but also to the shareholders.  And there is a cost to the shareholders for holding that back,” Wellman said.

Altaba CEO Thomas McInerney testified on day one of the trial that the company currently has its reserves invested very conservatively (earning a return of only four one-hundredths of 1 percent), and that, if the excess were distributed out to shareholders, the average investor could put that in the stock market and see much higher returns.  While Altaba’s Board of Directors owes a fiduciary duty to the company’s shareholders, we suspect Judge Laster will be more concerned about the rights of creditors in this proceeding.

IRS Signaling No New Issues

The two expert witnesses who testified during the Verizon tax-related indemnity portion of the trial were both former IRS executives.  But neither spoke to the technical substance of the underlying tax disputes.  Instead, they generally discussed the exam process and the extent to which they believed that the 2016/2017 audit was essentially complete such that additional holdback is unnecessary.

Altaba’s expert Barry Shott testified that it was highly unlikely that any additional material issues will be identified at this stage of the exam.  He said that—with respect to the substantive tax issues that were the subject of the 13 NOPAs issued for 2016/2017—it is “unlikely at this point” that the IRS would change its position on those issues.  “At this late stage, I just don’t see it happening,” Shott said.  Further, Shott said that the 2016/2017 exam would effectively be complete upon the issuance and signing by the taxpayer of the RAR.

Verizon’s expert Sharon Katz-Pearlman reiterated that a NOPA is still just a proposed adjustment.  Even if it is signed by the taxpayer, it is not binding, and NOPAs are superseded when the exam team determines that adjustments need to be made.  She stressed that if new information comes to light, new issues could be pursued.  Although Katz-Pearlman acknowledged that, as the team gets closer to issuing the RAR, the consideration of new issues becomes more unlikely, she gave a couple of examples of where she has seen it happen.

The most persuasive evidence for Altaba’s assertion that it does not expect the IRS to throw it any curve balls was actually provided by Wellman and not the experts.  She pointed to the fact that the IRS has already allowed Altaba to reduce the $1.767 billion reserve set forth in the August 2020 IRS-Altaba Agreement down to $1.740 billion.  “They wouldn’t be allowing us to reduce it—especially three different times—if they were identifying new issues,” she said.

But one of the strangest moments of the trial occurred during the cross-examination of Shott.  Counsel for Verizon seemed to be suggesting that one of the IRS employees who has been involved in Altaba’s exam may have a conflict of interest.  Shott was asked what types of major events might cause an exam team to decide to reopen what was effectively an almost closed case.  Shott said it could happen if suddenly it becomes public knowledge that, for example, there was fraud committed that might have played into the tax return.

“And what if agents on the team have a conflict of interest?” Verizon counsel asked.  Shott responded:  “One of the things managers are required to consider is to take a look at whether there are conflicts.  I wouldn’t say they ask a lot of questions about it,” he said.  “If a revenue agent were to have a conflict and it was discovered at a later date, I can’t tell you exactly what the IRS would do because I’ve never seen that, but my guess is that they would revisit everything that revenue agent did on that case and assign someone else. . . . Throw it away . . . and let’s start over again examining the issue,” Shott said.

Some ten minutes later, during questioning regarding the involvement in the audit of Gloria Sullivan, director of Western compliance, IRS Large Business and International Division (LB&I), the conflict of interest topic was raised again.  Shott had just agreed that, in his expert reports and in his deposition, he put a lot of weight into Sullivan’s involvement in Altaba’s exam.  Shott had said that statements by IRS executives supervising the Altaba audit can and should be relied on, including statements made by Sullivan.  “I think you can rely on everything Ms. Sullivan says,” Shott testified April 21.  “I have not seen an IRS executive willfully lie or misstate something to a taxpayer.  So I think you can rely on Ms. Sullivan’s comments, whatever they were.”

Then Verizon’s counsel asked:  “But what if she has a conflict of interest?”

“If she had a conflict of interest, we would discover that down the road.  Perhaps we might even discover it now,” Shott said.  “But I will tell you that executives at IRS, like executives in all of the other agencies, are required to annually disclose their financial interests . . . everything has to be disclosed.  All of that information is reviewed by the Office of General Counsel in the [IRS] Chief Counsel’s office. . . . They are looking for conflicts like that,” he said.  “If Ms. Sullivan were conflicted—and it came up—I think IRS would relook at this case.”

Verizon’s counsel then asked if Shott knows if Sullivan is planning to leave the IRS.  “I’ve heard rumors she is, yes.  She’s reached retirement age,” Shott said, adding in response to another question that he has no idea if she is planning to accept a job offer anytime soon.  “It’s been years since I’ve spoken to her,” Shott said.

To be clear, we did not hear Verizon’s counsel offer up any direct basis for there being a conflict, just an insinuation.

Applicability of Penalties

One final tax issue that came up during day two was whether the IRS might impose a 20 percent accuracy related penalty pursuant to IRC Section 6662.  For example, Section 6662(d) generally provides that if a corporation understated the amount of its income tax on its return for any taxable year by (in Altaba’s case) more than $10 million (considered to be a substantial understatement), then the IRS may impose a penalty equal to 20 percent of the underpayment.

In its pre-hearing brief, Verizon states that “the adjustments Altaba concedes the IRS examination team is considering in the 2016-2017 audit would result in an understatement of income tax that exceeds the threshold amount that ordinarily triggers imposition of a substantial understatement penalty.” ¹² 

However, there are defenses to such a penalty.  If the taxpayer can demonstrate “that there was reasonable cause for, and the taxpayer acted in good faith with respect to” the understatement, then the penalty will not be sustained. ¹³ 

Shott mentioned that such a reasonable cause and good faith defense may not work if the understatement relates to a position—taken in reliance on professional advice—that was inconsistent with guidance set forth in Treasury regulations, unless the taxpayer adequately disclosed such a position.  Shott said that because Altaba made such disclosures (in connection with certain transfer pricing issues), it is protected.  But, as Verizon’s counsel pointed out, Altaba still must establish the facts and circumstances for a reasonable cause and good faith defense to a substantial understatement penalty with respect to all other issues.

Katz-Pearlman acknowledged that, in general, a large case exam team is supposed to send information document requests (IDRs) to a taxpayer in cases where the substantial understatement penalty may apply in order to give the taxpayer an opportunity to establish that it can satisfy the reasonable cause defense.  No such penalty-related IDRs have been issued in this exam, nor has the team even mentioned the word penalty, according to Wellman.

But the IRS does not always handle its exams by the book.  “It’s not supposed to happen” that the IRS raises the substantial understatement penalty at the last minute.  “But it does happen, yes,” Katz-Pearlman said.

^{[1] See our prior report “Altaba’s Request for Second Interim Distribution Is Denied by Chancery Court Judge on Eve of Hearing” (April 19, 2021); $2,885,180,414 / 519,511,366 shares issued and outstanding as of Dec. 31, 2020 = about $5.55 / share}

^{[2] In this report, references to Verizon should be read to include Oath Holdings Inc., formerly known as Yahoo! Holdings, Inc.}

^{[3] Specifically, an order pursuant to Section 280 setting forth the holdback amounts, including for the disputed items discussed at trial and as required under Section 280(c)(3), and allowing Altaba to distribute the remaining funds to its shareholders.}

^{[4] “Petitioner Altaba Inc.’s Unopposed Motion for An Second Interim Order Approving Interim Holdbacks and Permitting Certain Distributions to Stockholders,” filed April 15, 2021 (Case No. 2020-0413-JTL).}

^{[5] Other developments of note disclosed during day two of the trial:  The IRS agreed to a $70 million 2016 foreign tax credit (FTC) carryover, which can be applied to Altaba’s 2017 tax year to reduce its federal income tax liability.  Potentially in addition to that, according to Wellman, Altaba acknowledged that it may have been double counting a Section 305 distribution’s impact on the pool of earnings and profits (E&P) used to calculate FTCs related to Altaba’s investment in Yahoo Japan.  “Once we rolled that reconciliation forward, we identified a small error that was actually in our benefit,” Wellman said, adding that “we were getting a double taxation.  So once you remove that, we actually had more credits.” She said the error is in the range of $20 million to $50 million.  “What we told them is we’re going to push that item . . . into 18/19 so we can close the 16 and 17 years.”}

^{[6] “Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment.”}

^{[7] Altaba’s predecessor, Yahoo! Inc., sold its operating business to Verizon in 2017, making Verizon severally liable for certain of the predecessor’s potential taxes under Treas. Reg. §1.1502-6, which provides that provides that all members of a consolidated federal income tax group are severally liable for the taxes of the group.}

^{[8] During April 21 testimony, William Van Saders, the Senior Vice President and Deputy General Counsel of Corporate Taxes at Verizon, indicated that Verizon may need to further adjust down its claim to account for an even lower blended state income tax rate for 2017 that potentially entirely excludes California.  It is Altaba’s position that the correct blended state income tax rates for 2016 and 2017 are 1.76% and 1.85%, respectively, according to “Altaba Inc.’s Pre-Hearing Reply Brief in Further Support of Its Proposed Final Security for Verizon’s Claims” at 18, filed April 20, 2021 (Case No. 2020-0413-JTL).}

^{[9] $9,035,467 according to “Complaint to Reduce Tax Liabilities to Judgment” (the IRS Complaint) in U.S. v. Altaba Inc., D. Del., filed June 16, 2020 (Case No. 1:20-cv-00811-LPS).  See also page 30 of Exhibit E (page ID# 116) to the IRS Complaint.}

^{[10] “Altaba Inc.’s Pre-Hearing Opening Brief in Support of Its Proposed Final Security for Verizon’s Claims” at 23, filed March 18, 2021 (Case No. 2020-0413-JTL).}

^{[11] “Joint Pre-Trial Order” at 50, filed April 15, 2021 (Case No. 2020-0413-JTL).}

^{[12] “Pre-Hearing Brief of Claimants Verizon Communications Inc. and Oath Holdings Inc.” at 54, filed April 7, 2021 (Case No. 2020-0413-JTL).}

^{[13] Treas. Reg. §1.6664-4(a).}