Merck to Get a Cash Payment In Spinning Off Medco

Tired of waiting for an upturn in the IPO market, Merck & Co. has decided to pull the trigger on shedding its pharmacy benefits management (PBM) operation through a tax-free spin-off. Although Merck lost time in executing its restructuring, the drug company actually adopted a simpler divestment technique and probably won’t suffer a financial hit as a result of the spin-off. Merck originally acquired the PBM unit, Medco Health Solutions, as a vehicle for controlling the pharmaceutical supply chain from manufacturer to the ultimate consumer. More recently, this strategy has been criticized as an overreach on the part of a drug developer. The IPO was scrubbed last July because of the difficulty in selling any kind of new issue in the marketplace. The problems for the Medco IPO were compounded by the company’s method of accounting for co-payments on drugs by insured consumers. Medco booked the co-payment as part of its revenues and included an offsetting charge to prevent the technique from inflating earnings. Despite the controversy, Robert Willens, a tax expert at Lehman Brothers, says that the accounting was appropriate because Medco served as the obligator of the payments. Merck was expected to generate about $1 billion from the IPO of a partial interest in Medco and subsequently spin off its remaining interest to shareholders. The 2003 version is a one-step spin-off, which still allows Merck to reap cash from the deal. To replace the proceeds of the stock sale, Medco will raise money through debt financing and turn it over to Merck in a cash dividend. Levitt Returning To Public Trading In another spin-off involving potential conflicts between a parent and its customers, BankAtlantic Bancorp said it would cut loose its Levitt Corp. home building subsidiary in a tax-free transaction. The spin-off will return Levitt to public ownership. BankAtlantic did not mention potential conflicts in announcing its restructuring plan. Instead CEO Alan B. Levan said that the move essentially was designed to free up the ability of both BankAtlantic and Levitt to raise needed capital for financing growth. Capital raising is considered a legitimate business purpose in executing a tax-free spin-off. Spin-Offs for In-Line Diversification An IRS ruling has widened the options for expanding companies to execute strategic restructurings through tax-free spin-offs. The new ruling resurfaced the long-permitted but rather obscure policy that allows the acceleration of spin-offs designed to split a parent from a unit formed in the relatively recent past if both operations are in the same line of business. But it also adds an important dimension to the scope of the policy. Typically, IRS rules require a parent to own and operate an active business for five years before it can be spun off tax-free. But there is an exception if the sub is an “expansion” of the parent’s main line of business. In those cases, the parent can move faster on the disposition. Willens, in a recent analysis, cited an example of how the expansion doctrine works. An auto dealership group bought another chain that sold a competing brand. A subsequent spin-off went through tax-free because the firms were in the same line of business – selling and servicing cars. A more recent ruling took the “expansion concept to a new level,” he wrote. In this case, a shoe retailer launched a web site to sell shoes and moved only two years later to spin it off. The deal went through tax-free because of the expansion concept. Although the ruling had the potential to impact a large number of industries, its most clear-cut effect is on merchandisers that open new distribution channels for their wares. Willens pointed out the key facets of the deal, such as that buying and selling shoes was the same business both in stores and on the Internet but that web sales require “some know-how not associated with operating a retail store.” In addition, the web site draws on the parent’s experience and reputation. The “totality” of factors indicates that the web site was an expansion that qualified for tax-free treatment when spun off. Copyright 2003 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com