Shares of Yahoo, which have fallen about 45 percent this year, touched a high of $29.23 on the Nasdaq on Tuesday. Alibaba shares were up 1 percent at $57.97 in morning trading.

Yahoo had sought a private letter ruling from the U.S. Internal Revenue Service (IRS) to confirm if the transaction - potentially worth about $23 billion - would result in a tax obligation. The U.S. tax regulator denied the request.

If the IRS denies the tax-free status later, Yahoo's shareholders may have to pay some $9 billion in taxes.

The IRS said earlier this month that it was working to amend the rules on taxing spinoffs. But an IRS official later indicated that any amendments would not apply retroactively, implying that Yahoo's spin off could be tax free.

"In our opinion, the IRS is maintaining the status quo on this issue, and with no changes to guidance on this matter, we believe that Yahoo should be able to complete this transaction in a tax-free manner," Mizuho Securities analysts wrote in a note.

Yahoo expects to complete the deal in the fourth quarter ending Dec. 31.

The company may be able to complete the transaction before the new rules come into effect, SunTrust Robinson Humphrey analyst Robert Peck said in a research note.

Yahoo has been struggling to revive its core online advertising business. Chief Executive Marissa Mayer has been under intense pressure from shareholders to spin off Yahoo's 15 percent stake in Alibaba.

The value of the stake has halved this year as Alibaba's shares slid amid China's slowing economy and increased competition from smaller rival JD.com Inc.

Mizuho cut its price target on Yahoo's stock to $40 from $43, based on Alibaba's lower valuation, joining several other brokerages that have done so this month.

(Reporting by Sayantani Ghosh in Bengaluru; Editing by Ted Kerr and Savio D'Souza)