Pharmacy benefits management company Express Scripts Inc. signed a definitive agreement last month with WellPoint Inc., under which Express Scripts will acquire Wellpoint’s “NextRx subsidiaries” for $4.675 billion — an amount which includes consideration “for the value of a future tax benefit for Express Scripts based on the structure of the transaction.” But what future tax benefit are they referring to?
Indeed, Wellpoint (through subsidiaries) will be selling the sole membership interest in a limited liability company, namely Next RX LLC, to Express Scripts. For tax purposes, Next Rx is a “disregarded entity” and Wellpoint will also be selling 100 percent of the stock of each of Next Rx Inc. and Next Rx Services Inc.
The consideration for the LLC interest totals $3.553 billion which will be delivered in the form of $2.489 billion in cash and the remainder in shares of common stock of Express Scripts. Deal considerations will be distributed in the following manner: For Next Rx Inc., Wellpoint will receive $841.5 million, of which $589 million will be in the form of cash and the remainder in shares of Express Script common stock; for Next Rx Services Inc., Wellpoint will receive $280.5 million, of which $196 million will be in the form of cash supplemented by $84.5 million in shares of Express Script common stock.
Therefore, in the aggregate, some 70 percent of the consideration conveyed by Express Scripts to Wellpoint will be in cash, and the remainder of the consideration will be comprised of Express Scripts newly-issued common stock.
The agreement provides that, (1) the parties will treat the purchase by Express Scripts of the LLC interest as a purchase of assets, and (2) Express Scripts and Wellpoint will jointly “complete and make” an election under the tax code — specifically Section 338(h)(10) — with respect to Next Rx Inc. and Next Rx Services Inc. Making such an election under Section 338 allows for certain tax benefits related to the recognition of gains and losses.
Here, as in most Section 338(h)(10) situations, a portion of the benefit will be “shared” with the seller in the form of a higher purchase price for the properties. — Robert Willens.
For instance, Express Scripts will secure a cost basis in the assets acquired, and in the process gain access to the benefits of Section 197(a) of the tax code, the provision related to the amortization of goodwill and other intangible assets. That means that the amounts paid for the intangible assets obtained in the acquisition, most notably customer lists and similar “customer based intangibles,” will be amortized over a 15-year period with the result that Express Scripts’s taxable income, and therefore its cash tax obligations, will be markedly reduced. Here’s how the tax code works in this instance:
An election under Section 338(h)(10) may be made for a target company if a corporation acquires enough of the target’s stock to meet the requirements of Section 1504(a)(2) — which is 80% — and is selling a consolidated group in a “qualified stock purchase.”
Each condition will be met in this case, in light of the fact that Express Scripts will be purchasing 100 percent of the stock from a selling consolidated group comprising Next Rx Inc. and Next Rx Services Inc. Moreover, even though a portion of the consideration conveyed to Wellpoint consists of its common stock, the acquisition of the stock of the Next Rx entities will constitute a qualified stock purchase.1
In addition, election under Section 338(h)(10) must be made jointly by the purchaser and the selling consolidated group. If the election is made, the target(s) is treated as transferring all of its assets to an unrelated person in a single transaction at the close of the acquisition date. The target will recognize all of the gain realized on this deemed transfer of its assets and will recognize the “deemed sale tax consequences” while it is a member of the selling consolidated group. What’s more, the gain from the deemed sale of assets is reported on the selling group’s consolidated tax return.
Immediately after the deemed sale of assets — and while it is a member of the selling consolidated group — the target is then treated as if it transferred all of its assets (comprising the proceeds from the deemed sale of its operating assets) to members of the selling consolidated group, and ceased to exist. In most cases, this transfer will be treated as a distribution in complete liquidation, and therefore should be tax-free under the tax code (See Section 332 and Section 337.)
In the end, the result of the election is a cost basis in the acquired assets (both tangible and intangible) at the cost of only a single level of tax imposed on the selling consolidated group.2
It is difficult to quantify the benefit Express Scripts will obtain from the cost basis the election enables it to enjoy. This benefit varies directly with the magnitude of the basis step-up, and to know the size of the basis step-up we would have to know the basis at which these assets were held while they resided in the Wellpoint group.
However, it is an investment banking rule of thumb that the ability to secure a cost basis in acquired assets — and in the process, gain access to the benefits of Section 197(a) — reduces the “effective cost” of the deal by approximately 20 percent. Of course, here, as in most Section 338(h)(10) situations, a portion of the benefit will be “shared” with the seller in the form of a higher purchase price for the properties. Accordingly, it is probable that the 20 percent benefit will be equitably shared by Wellpoint and Express Scripts with each enjoying roughly 50 percent of the overall benefit.
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com
1This will be true even if, as part of the overall plan, Express Scripts causes each of Next Rx Inc. and Next Rx Services Inc. to merge with and into Express Scripts (or an affiliate) and the stock acquisitions and mergers are properly viewed as a single transaction which constitutes a reorganization under Section 368(a)(1)(A). See King Enterprises, Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969). The regulations provide that an election under Section 338(h)(10) may be made for a target where a purchaser’s acquisition of target’s stock viewed independently constitutes a qualified stock purchase (the case here), and after the target merges or liquidates into the purchaser (or an affiliate of the purchaser) whether or not under relevant provisions of law (including the step transaction doctrine) the acquisition of stock and merger or liquidation, taken together, qualify as a reorganization. See Reg. Section 1.338(h)(10)-1(c)(2).
2Purchasers always want an election under Section 338(h)(10). Whether the seller will be willing to join the purchaser in the election depends largely on the relative magnitude (not the absolute amount) of the seller’s “outside basis” in the target’s stock compared with the latter’s “inside net basis” in its assets. If the outside basis is higher, a sale of stock, without an election under Section 338(h)(10), will produce less taxable gain. Presumably, in that event, the seller will be unwilling to join the buyer in executing the election. See M. Ginsburg and J. Levin, Mergers, Acquisitions, and Buyouts, Paragraph 206.