SEPARATION OF BAXALTA INCORPORATED

3 Months Ended

Mar. 31, 2016

SEPARATION OF BAXALTA INCORPORATED

2. SEPARATION OF BAXALTA INCORPORATED

After giving effect to the Distribution, the company retained 19.5% of the outstanding common stock, or 131,902,719 shares of Baxalta (Retained Shares). Effective January 27, 2016, Baxter completed a debt-for-equity exchange through the transfer of 37,573,040 Retained Shares in exchange for the extinguishment of the $1.45 billion aggregate principal amount of indebtedness outstanding under the U.S. dollar denominated revolving credit facility. Additionally, on March 16, 2016, the company completed a debt-for-equity exchange, in which Baxter exchanged 63,823,582 Retained Shares for the extinguishment of $2.2 billion in aggregate principal amount of Baxter indebtedness. See Note 8 for additional details regarding these debt-for-equity transactions. Baxter accounts for its investment in these Retained Shares as available-for-sale equity securities with a fair value of approximately $1.2 billion and $5.1 billion as of March 31, 2016 and December 31, 2015, respectively.

For a portion of Baxalta’s operations, the legal transfer of Baxalta’s assets and liabilities did not occur with the separation of Baxalta on July 1, 2015 due to the time required to transfer marketing authorizations and other regulatory requirements in certain countries. Under the terms of the International Commercial Operations Agreement (ICOA), Baxalta is subject to the risks and entitled to the benefits generated by these operations and assets until legal transfer; therefore, the net economic benefit and any cash collected by these entities are transferred to Baxalta.

Following is a summary of the operating results of Baxalta, which have been reflected as discontinued operations for the three months ended March 31, 2016 and 2015. The assets and liabilities have been classified as held for disposition as of March 31, 2016 and December 31, 2015.

	Three months ended March 31,
(in millions)	2016			2015
Major classes of line items constituting income from discontinued operations before income taxes
Net sales	$	64		$	1,362
Cost of sales		(59	)		(580	)
Marketing and administrative expenses		(20	)		(231	)
Research and development expenses		—			(157	)
Other income and expense items that are not major		—			(2	)
(Loss) income from discontinued operations before income taxes		(15	)		392
Gain on disposal of discontinued operations		17			—
Income tax expense		9			96
(Loss) income from discontinued operations, net of tax	$	(7	)	$	296

	March 31,		December 31,
(in millions)	2016		2015
Carrying amounts of major classes of assets included as part of discontinued operations
Accounts and other current receivables, net		$   99		$ 228
Inventories		9		8
Property, plant, and equipment, net		1		2
Other		2		7
Total assets of the disposal group		$  111		$ 245
Carrying amounts of major classes of liabilities included as part of discontinued operations
Accounts payable and accrued liabilities		$     2		$  46
Other long-term liabilities		8		—
Total liabilities of the disposal group		$   10		$  46

As of March 31, 2016 and December 31, 2015, Baxter has recorded a liability of $92 million and $190 million, respectively, for its obligation to transfer these net assets to Baxalta. On February 1, 2016, the legal transfer of approximately $90 million of net assets as of December 31, 2015 was distributed to Baxalta resulting in a gain of $17 million, which is recorded within income from discontinued operations, net of tax. It is expected that the majority of the remaining operations will be transferred to Baxalta during 2016.

Baxter and Baxalta entered into several agreements in connection with the July 1, 2015 separation, including a transition services agreement (TSA), separation and distribution agreement, manufacturing and supply agreements (MSA), tax matters agreement, an employee matters agreement, a long-term services agreement, and a shareholder’s and registration rights agreement.

Pursuant to the TSA, Baxter and Baxalta and their respective subsidiaries are providing to each other, on an interim, transitional basis, various services. Services being provided by Baxter include, among others, finance, information technology, human resources, quality supply chain, and certain other administrative services. The services generally commenced on the Distribution date and are expected to terminate within 24 months (or 36 months in the case of certain information technology services) of the Distribution date. Billings by Baxter under the TSA are recorded as a reduction of the costs to provide the respective service in the applicable expense category, primarily in marketing and administrative expenses, in the condensed consolidated statements of income. In the first quarter of 2016, the company recognized approximately $27 million as a reduction to marketing and administrative expenses related to the TSA. Pursuant to the MSA, Baxalta or Baxter, as the case may be, manufactures, labels, and packages products for the other party. The terms of the agreements range in initial duration from five to ten years. In the first quarter of 2016, Baxter recognized approximately $11 million in sales to Baxalta. In addition, Baxter recognized $45 million in cost of sales related to purchases from Baxalta pursuant to the MSA. The cash flows associated with these agreements are included in cash flows from operations — continuing operations.

Cash outflows of $159 million were reported in cash flows from operations – discontinued operations for the period ending March 31, 2016. These relate to non-assignable tenders whereby Baxter remains the seller of Baxalta products, transactions related to importation services Baxter provides in certain countries, in addition to trade payables settled post local separation on Baxalta’s behalf.