Yahoo currently owns 15 per cent of Alibaba group and will create another company made up of its stake worth around £26bn. Yahoo shareholders will receive all of the company's 384m Alibaba shares.
"Yahoo believes this transaction will achieve the most advantageous return of capital to our shareholders with the absolute highest probability of success", said Yahoo.
Yahoo's share price jumped seven per cent in after-hours trading on Tuesday. The spin-off is expected to be concluded in the fourth quarter after Yahoo's lock-up agreement on Alibaba shares expires.
The company also reported fourth-quarter earnings below analysts' expectations with revenue coming in at £780m. This is almost half of what Yahoo reported the same time last year.
Display advertising revenue dropped four per cent to £350m. However, mobile revenue climbed 23 per cent to £167m. Yahoo's chief executive Marissa Mayer said in a statement:
I'm pleased to report that our performance in Q4 and in 2014 continues to show stability in our core business.
Our mobile strategy and focus has transformed Yahoo and yielded significant results.
Yahoo is expecting revenue for the first quarter to be around $1bn