Illumina May Divest GRAIL—What Are the Tax Impacts?

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

On October 12, the European Commission ordered U.S.-headquartered DNA sequencing provider Illumina, Inc. (NASDAQ:  ILMN) (Illumina) to sell or separate off its U.S.-headquartered healthcare company GRAIL within the next 12 months. ¹  In this report, we will discuss the potential tax consequences of such a divestiture.

The EC order is just the latest development in a bizarre saga that began in 2015, when Illumina formed GRAIL, Inc. with unrelated third party investors to make multi-cancer early detection (MCED) blood tests.²  Illumina is the only supplier of a critical input for the MCED tests. ³  While Illumina obtained majority equity ownership in GRAIL in 2016, ⁴ within a few years, it had sold the bulk of its interest in GRAIL to a group of private investors ^[5] and deconsolidated GRAIL (which, at the time, was still pre-revenue) in 2017. ⁶ 

By September 2020, when Illumina announced that it wanted to reacquire GRAIL for cash and stock consideration of some $8 billion, Illumina only owned about 14.5 percent of GRAIL’s outstanding shares. ⁷  The planned reacquisition of GRAIL was subject to “customary closing conditions, including applicable regulatory approvals.” ⁸ While it was expected that the reacquisition would occur by the outside date of September 20, 2021 (subject to extension), the terms provided that the Merger Agreement⁹ could be terminated “if a governmental entity of competent jurisdiction has issued or granted an order, judgment, decree, ruling or injunction that results in a permanent restraint that has become final and non-appealable . . . . ” ¹⁰ 

In March 2021, the U.S. Federal Trade Commission (FTC) filed an administrative complaint arguing that “[a]llowing Illumina to purchase Grail . . . would cause substantial harm to U.S. consumers.” ¹¹  The FTC went to federal court to seek a preliminary injunction blocking the merger, which the FTC alleged would violate Section 7 of the Clayton Act, as amended. ¹²   But a month after the European Commission (EC) initially agreed to review the case in April 2021, the FTC decided to dismiss the injunction to conserve its resources.  In justifying the dismissal, the FTC said that “[n]ow that the European Commission is investigating, Illumina and GRAIL cannot implement the transaction without obtaining clearance from the European Commission.” ¹³ 

Illumina felt differently, apparently.  On August 11, 2021, Illumina CEO Francis A. deSouza said, “In terms of the deal, there is no impediment to us closing in the U.S. right now.  The FTC had [an] injunction on us but dismissed the injunction.”  He added that the FTC’s suit is going to trial, and Illumina is “challenging the jurisdiction of the European Commission to review the deal.” ¹⁴ 

Just days later and despite the numerous moving parts, Illumina completed the reacquisition of GRAIL on August 18, 2021, but provided that GRAIL would remain “a separate and independent unit, pending ongoing regulatory and legal review.” ¹⁵  Illumina insisted that “GRAIL has no business in the EU, and the company believes that the European Commission does not have jurisdiction to review the merger as the  EU merger thresholds are not met.”¹⁶ Further, it said that “Illumina is committed to working through the ongoing FTC administrative process, and as always, will abide by whatever outcome is ultimately reached in the US courts.” ¹⁷ 

Fast forward to today, and the FTC dispute is currently pending in the Fifth Circuit, after Illumina appealed the FTC’s final order ¹⁸ issued March 31, 2023 requiring Illumina to divest of GRAIL (after an administrative law judge initially dismissed¹⁹ the FTC’s complaint).  Because of the appeal, the FTC’s unwind decision is paused until final resolution.  With respect to the EC’s unwind order, Illumina noted that its challenge to the EC’s jurisdiction remains pending at the European Court of Justice (ECJ), but said it “has already begun the preparatory work necessary for divestment, if needed.” ²⁰   It stressed that “if Illumina is not successful with either its ECJ jurisdictional appeal or in a final decision of the U.S. Fifth Circuit Court of Appeals, the company will divest GRAIL.” ²¹  In a November 9, 2023 earnings release, Illumina said it “retained advisors and [is] preparing for sale and capital markets transaction options for GRAIL, including filing a Form 10, in accordance with the European Commission’s divestiture order; a Board special committee has been established to expedite decisions; in parallel, ongoing appeals preserve flexibility for any divestiture of GRAIL and future transactions.” ²² 

The impending threat of an unwind order spurred Illumina investor Carl Icahn to launch a proxy battle, blaming Illumina’s leadership for going forward with the reacquisition before it was approved by regulators. ²³   Icahn is concerned about the “mammoth tax bill” that could be triggered by the forced divestiture, which he estimates could exceed $2 billion. ²⁴ 

Stepping back a bit, in connection with the reacquisition, GRAIL stockholders (including Illumina, which at the time of the reacquisition, owned 12 percent of GRAIL ²⁵ ) received (i) $2.9 billion aggregate cash, (ii) shares of Illumina common stock, subject to a collar, and, (iii) at their election, either a contingent value right (CVR) at an aggregate fair value of about $615 million (as of January 2, 2022) or additional shares of Illumina common stock. ²⁶  The CVR entitled holders to receive future cash payments representing a 2.5 percent payment right to the first $1 billion of GRAIL-related revenue each year for 12 years.  Revenue above $1 billion each year will be subject to a 9 percent contingent payment right during the same period.  Upon closing of the transaction, pre-closing Illumina stockholders were expected to own approximately 93 percent of the combined company, while GRAIL stockholders were expected to own approximately 7 percent based on the mid-point of the collar. ²⁷ 

Tax Impacts of Divestiture

As Carl Icahn noted, Illumina could satisfy a divestiture order by selling GRAIL, incurring a significant income tax cost.  The obvious no-tax cost alternative would be a tax-free spin-off of GRAIL to Illumina’s shareholders.  But would such a spin-off qualify under Section 355 of the Internal Revenue Code (IRC)?

The key issue is the active trade or business (ATB) requirement under Section 355(b), which generally requires that Illumina and GRAIL each be engaged in an ATB that has been actively conducted throughout the preceding five-year period and was not acquired by Illumina during that period in a transaction in which any taxable gain or loss was recognized.  Pick your metaphor—for GRAIL to satisfy the ATB tests, the company must make it through a mine field (for pessimists) or an obstacle course (for optimists).

One question is whether GRAIL on a stand-alone basis can be said to have been engaged in an ATB for the previous five years.  Under the regulations, a corporation is engaged in an ATB “if a specific group of activities are being carried on . . . for the purpose of earning income or profit,” ²⁸ and requires the corporation “perform active and substantial management and operational functions.” ²⁹   The group of activities “ordinarily must include the collection of income and the payment of expenses.” ³⁰   It is reasonably clear that GRAIL has had the requisite level of activity for at least five years, but it has not generated revenue during this entire period. ³¹  Fortunately, the Internal Revenue Service (IRS) has made clear that, especially in the biotechnology space, it is willing to put aside the general requirement that there be both revenue and expense and has ruled favorably on such a company meeting the ATB test without yet generating revenue. ³² 

A problem arises, however, from the fact that Illumina bought out the GRAIL outside investors in 2021 in a merger that included both stock and cash consideration.  As a result, on its face, this would seem to violate the rule against acquiring control of a corporation carrying on the ATB during the previous five years in a transaction that was not entirely tax-free. ³³  Can they defer the divestiture until after the fifth anniversary of Illumina’s acquisition of GRAIL, in August 2026?  While it usually doesn’t pay to bet on the fast and efficient operation of the legal process, it is unlikely that the process will be delayed that much.  Illumina has confirmed its intention, consistent with the EC divestiture order, to divest GRAIL within a year of a final resolution to the legal dispute (although there is potential for a three-month extension)^. 34 

We think it likely that Illumina will be able to rely on the well-established “expansion” doctrine, where a corporation that is already engaged in an active trade or business makes one or more taxable purchases of business operations that merely expand the scope of that trade or business.  Provided the acquisition is considered to be an expansion of the existing business rather than the acquisition of a new business, the acquired assets may be spun off without waiting for five years. ³⁵  Where the taxable acquisition takes the form of a stock purchase, there are certain technical issues to address apart from the central active business question, but the form of the purchase (the re-acquisition, in this case) should not ultimately be an impediment. ³⁶ 

Specifically, unless the company decides the better course is a taxable sale, we expect Illumina would pursue a tax-free spin-off, requesting a private letter ruling from the IRS that GRAIL’s cancer detection blood test endeavor was an outgrowth of Illumina’s historical genetic analysis business.  There is good reason to expect they would get the ruling

^{[1] Press Release, EC, Commission orders Illumina to unwind its completed acquisition of GRAIL (Oct. 12, 2023) (https://ec.europa.eu/commission/presscorner/detail/en/ip_23_4872).}

^{[2] Federal Trade Commission, Complaint (public redacted version), March 30, 2021 (https://www.ftc.gov/system/files/documents/cases/redacted_administrative_part_3_complaint_redacted.pdf) .}

^{[3] Id.}

^{[4] Press Release, Illumina, Illumina to Acquire GRAIL to Launch New Era of Cancer Detection (Sept. 21, 2020) (https://www.sec.gov/Archives/edgar/data/1110803/000095015720001121/ex99-1.htm).}

^{[5] The private investors included ARCH Venture Partners, Johnson & Johnson Innovation, Bill Gates and Jeff Bezos. Press Release, GRAIL, GRAIL Closes Over $900 Million Initial Investment in Series B Financing to Develop Blood Tests to Detect Cancer Early (March 1, 2017) (https://grail.com/press-releases/grail-closes-over-900-million-initial-investment-in-series-b-financing-to- develop-blood-tests-to-detect-cancer-early/); David Goldman, Bill Gates and Jeff Bezos pour millions into new cancer test, CNN, Jan. 11, 2016 (https://money.cnn.com/2016/01/11/technology/grail-cancer-gates-bezos/).}

^{[6] Illumina, Annual Report (Form 10-K), filed Feb. 11, 2020 (https://www.sec.gov/ix?doc=/Archives/edgar/data/0001110803/000111080320000018/form10-k2019classic.htm).}

^{[7] Press Release, Illumina, Illumina to Acquire GRAIL to Launch New Era of Cancer Detection (Sept. 21, 2020) (https://www.sec.gov/Archives/edgar/data/1110803/000095015720001121/ex99-1.htm).}

^{[8] Id.}

^{[9] Agreement and Plan or Merger among Illumina, GRAIL and others, dated Sept. 20, 2020 (Merger Agreement) (https://www.sec.gov/Archives/edgar/data/1110803/000095015720001121/ex2-1.htm); see also Amendment to Agreement and Plan of Merger, dated Feb. 4, 2021 (https://www.sec.gov/Archives/edgar/data/1110803/000095015721000121/ex2- 1.htm).}

^{[10] Illumina, Annual Report (Form 10-K), filed Feb. 17, 2021 (https://www.sec.gov/ix?doc=/Archives/edgar/data/0001110803/000111080321000015/ilmn-20210103.htm).}

^{[11] Supra, note 2.}

^{[12] Illumina, Annual Report (Form 10-K), filed Feb. 18, 2022 (https://www.sec.gov/ix?doc=/Archives/edgar/data/0001110803/000111080322000013/ilmn- 20220102.htm#i753d87927de64785869b7db62d811899_118).}

^{[13] Press Release, FTC, Statement of FTC Acting Bureau of Competition Director Maribeth Petrizzi on Bureau’s Motion to Dismiss Request for Preliminary Relief in Illumina/GRAIL Case (May 20, 2021) (https://www.ftc.gov/news-events/news/press- releases/2021/05/statement-ftc-acting-bureau-competition-director-maribeth-petrizzi-bureaus-motion-dismiss-request).}

^{[14] Transcript of remarks by Francis deSouza at the UBS Genomics 2.0 and MedTech Innovation Summit held on Aug. 11, 2021 (https://www.sec.gov/Archives/edgar/data/1110803/000095015721000835/form425.htm).}

^{[15] Press Release, Illumina, Illumina Acquires GRAIL to Accelerate Patient Access to Life-Saving Multi-Cancer Early-Detection Test (Aug. 18, 2021) (https://www.sec.gov/Archives/edgar/data/1110803/000095015721000850/ex99-1.htm).}

^{[16] Id.}

^{[17] Id.}

^{[18] FTC, Final Order (in the matter of Illumina and GRAIL), issued March 31, 2023 (https://www.ftc.gov/system/files/ftc_gov/pdf/d09401commissionfinalorder.pdf).}

^{[19] ALJ, Initial Dismissal (in the matter of Illumina and Grail), issued Sept. 9, 2022 (https://www.ftc.gov/system/files/ftc_gov/pdf/D09401InitialDecisionPublic.pdf).}

^{[20] Press Release, Illumina, Illumina responds to European Commission’s divestiture order (Oct. 13, 2023) (https://investor.illumina.com/news/press-release-details/2023/Illumina-responds-to-European-Commissions-divestiture- order/default.aspx).}

^{[21] Id.}

^{[22] Press Release, Illumina, Illumina Reports Financial Results for Third Quarter of Fiscal Year 2023 (Nov. 9, 2023) (https://www.sec.gov/Archives/edgar/data/1110803/000111080323000085/a3q23earningsrelease.htm).}

^{[23] Bhanvi Satija and Svea Herbst-Bayliss, Icahn launches proxy fight at Illumina, seeks board seats, Reuters (March 13, 2023) (https://www.reuters.com/business/activist-investor-icahn-launches-proxy-battle-illumina-2023-03-13/).}

^{[24] Carl C. Icahn Issues Open Letter to Shareholders of Illumina, Inc. dated April 24, 2023 (https://carlicahn.com/open-letter-to- shareholders-of-illumina-inc-5/).  See also May 1 letter (https://carlicahn.com/open-letter-to-shareholders-of-illumina-inc-7/), May 8 letter (https://carlicahn.com/open-letter-to-shareholders-of-illumina-inc-9/), May 11 letter (https://carlicahn.com/open- letter-to-shareholders-of-illumina-inc-10/), May 15 letter (https://carlicahn.com/open-letter-to-shareholders-of-illumina-inc- 11/), May 19 letter (https://carlicahn.com/open-letter-to-shareholders-of-illumina-inc-12/).  And see Illumina’s May 8, 2023 response (https://www.prnewswire.com/news-releases/illumina-sends-letter-to-shareholders-highlighting-board-strength- weakness-of-icahns-plan-301817959.html).}

^{[25] Illumina, Form 10-Q (Quarterly Report), filed Nov. 5, 2021 (https://www.sec.gov/ix?doc=/Archives/edgar/data/0001110803/000111080321000046/ilmn-20211003.htm).}

^{[26] Illumina, Form 10-K (Annual Report), filed Feb. 18, 2022 (https://www.sec.gov/ix?doc=/Archives/edgar/data/0001110803/000111080322000013/ilmn-20220102.htm).}

^{[27] Press Release, Illumina, Ilumina to Acquire GRAIL to Launch New Era of Cancer Detection (Sept. 21, 2020) (https://www.sec.gov/Archives/edgar/data/1110803/000095015720001121/ex99-1.htm).}

^{[28] Treas. Reg. §1.355-3(b)(2)(ii).}

^{[29] Treas. Reg. §1.355-3(b)(2)(iii).}

^{[30] Treas. Reg. §1.355-3(b)(2)(ii).}

^{[31] GRAIL generated $12 million of revenue in 2021, $55 million in 2022 and $42 million during the first half of 2023, according to securities filings.}

^{[32] See, e.g., PLR 202009002 (Feb. 28, 2020).}

^{[33] Treas. Reg. §1.355-3(b)(3)(C).}

^{[34] Press Release, Illumina, Illumina responds to European Commission’s divestiture order (Oct. 13, 2023) (https://investor.illumina.com/news/press-release-details/2023/Illumina-responds-to-European-Commissions-divestiture- order/default.aspx).}

^{[35] See Treas. Reg. §1.355-3(c) Examples 7 and 8 and Estate of Lockwood v. Comm’r, 350 F.2d 712 (8th Cir. 1965).}

^{[36] There is some technical inconsistency between certain statutory provisions in IRC §§ 355(b) and 355(a)(3)(B) and the later- added separate affiliated group (SAG) rules in §355(b)(3).  Proposed regulations on the SAG approach make clear that an acquisition of a corporation conducting a trade or business will be treated as if the underlying assets were acquired (Prop. Treas. Reg. §1.355-3).}