This article provides a detailed analysis of the recent case Express Scripts, Inc., and Express Scripts Holding Company v. United States of America, Case No. 4:21CV737 HEA, a decision from the United States District Court for the Eastern District of Missouri. This case addresses the applicability of the former Domestic Production Activities Deduction (DPAD) under 26 U.S.C. § 199 to a pharmacy benefit management company’s (PBM) claims adjudication software.

The case specifically allows an insight into how a court applied the Supreme Court’s Loper Bright Enters. v. Raimondo, 144 S.Ct. 2244 (2024) decision to its analysis of the underlying IRS regulations.

Facts of the Case

Express Scripts, Inc., and Express Scripts Holding Company (collectively, “Express Scripts”), headquartered in St. Louis, Missouri, brought consolidated actions seeking a refund of federal income taxes for the years 2010, 2011, and 2012. These claims were based on the assertion that Express Scripts properly claimed the DPAD pursuant to 26 U.S.C. § 199, which was in effect during those years. Express Scripts, following its merger with Medco Health Solutions, Inc. in 2012, became the largest PBM in the United States, holding over 40% of the market for PBM services.

Express Scripts’ customers, known as Plan Sponsors, included health insurers, employers, labor unions, managed care organizations, third-party administrators, and government health programs, who sponsored pharmacy benefit plans for their members ("Plan Members"). These plans covered the members’ use of prescription drugs.

Taxpayer’s Request for Relief

Express Scripts argued that it qualified for the former DPAD because it derived receipts from either (1) a license or other disposition of certain claims adjudication software it developed (the “Software”); or (2) providing its customers with access to that Software for their direct use. Express Scripts claimed significant amounts of domestic production gross receipts (DPGR) and qualified production activities income (QPAI) for the years in question:

2010: Claimed DPGR: $22,007 million; Claimed QPAI: $571 million
2011: Claimed DPGR: $22,434 million; Claimed QPAI: $768 million
2012: Claimed DPGR: $58,071 million; Claimed QPAI: $1,083 million

Express Scripts contended that these qualifying receipts were embedded within a “bundled fee” paid by plan sponsors for various PBM services. This bundled fee allegedly included ingredient costs, dispensing fees, administrative fees, and rebates and rebate administration fees from drug manufacturers. To arrive at its claimed DPGR, Express Scripts subtracted pass-through payments to pharmacies and customers, amounts allocable to embedded services using a transfer pricing approach, receipts from other claims adjudication software, and amounts related to mail-order pharmacy sales.

Court’s Analysis of the Law

The court began its analysis by noting that Section 199 allowed a deduction based on receipts from qualified domestic production gross receipts (DPGR). Qualifying Activities Income (QPAI) is derived by subtracting allocable costs and expenses from DPGR. The deduction was generally equal to 9% of the lesser of the QPAI or the taxpayer’s total taxable income and depended on the “disposition” of “qualifying production property,” which included “any computer software”. The IRS elaborated on the term “disposition” in regulations, specifying that § 199 allowed deductions based on revenues from sales but not revenues from services (26 C.F.R. § 1.199–3(i)(4)(i)(A)).

The court emphasized that the determination of whether Express Scripts was entitled to a refund was not limited by the Supreme Court’s decision in Loper Bright Enters. V. Raimondo, 144 S.Ct. 2244 (2024), as that case did not affect an agency’s rulemaking authority clearly conferred by statute. The court stated its role was to “independently interpret the statute and effectuate the will of Congress” within the boundaries of constitutionally permissible delegation.

Application of the Law to the Facts

The court found that the contracts between Express Scripts and its Plan Sponsors did not establish that Express Scripts granted licenses to the software. The Plan Sponsors had no direct access to the software, and the contracts explicitly stated that claims adjudication was a service provided by Express Scripts to the Plan Sponsors. The court highlighted that the origination of claims came from pharmacies or Plan Members (via switching companies), not directly from the Plan Sponsors submitting information to the software.

The court distinguished Express Scripts’ situation from cases where direct use of software by customers was found, such as Bloomberg L.P. v. Comm’r of Internal Revenue, T.C.M. (RIA) 2024-108 (T.C. 2024). In Bloomberg, customers directly used the analytical and graphing software to perform desired functions. In contrast, the court noted that submitting information to online software does not automatically equate to accessing or using the software directly, citing Direct Supply, Inc. v. United States, 635 F. Supp. 3d 685, 694 (E.D. Wis. 2022), aff’d, 96 F.4th 1031 (7th Cir. 2024), and BATS Glob. Markets Holdings, Inc. & Subsidiaries v. Comm’r of Internal Revenue, 158 T.C. 118, 147 (2022), aff’d, No. 22-9002, 2023 WL 4482553 (10th Cir. July 12, 2023).

Regarding the fee structure, the court observed that Express Scripts charged fees for ingredient costs, dispensing fees, and administrative fees, but not explicitly for claims adjudication or access to the Software. In fact, many contracts stated that claims adjudication services were provided at no additional cost. The court rejected Express Scripts’ argument that the cost of the software was included in a “bundled fee,” noting that none of the agreements mentioned or defined such a fee. The ingredient and dispensing fees were essentially reimbursements to pharmacies, and the administrative fees were generally tied to drug dispensing, not claims adjudication.

The court found the situation analogous to the examples provided in Treasury Regulations, such as an online system for ordering goods or providing reportage over the internet, which rely on software but do not “dispose” of that software (26 C.F.R. § 1.199–3(i)(6)(ii)).

Court’s Conclusions

Based on its analysis, the court concluded that the Express Scripts Agreements with its Plan Sponsors specifically designated claims adjudication as a service. Express Scripts did not license or otherwise dispose of its software as required by 26 U.S.C. § 199 and the related regulations. There were no separate fees charged for the software, and the Plan Sponsors did not directly access the software. The limited interaction with the software by pharmacies and Plan Members was merely for inputting information necessary for Express Scripts to perform the claims adjudication service.

Therefore, the court granted the United States’ Motion for Summary Judgment, finding that Express Scripts was not entitled to the DPAD under Section 199 as a matter of law.

Dismissal of Other Claims

The court also addressed and granted the Defendant’s Motion to Partially Dismiss Express Scripts’ Claims for Lack of Jurisdiction. This dismissal pertained to refund claims related to rebates and manually entered mail-order claims, which the court found to be barred by the substantial variance doctrine because they relied on facts not presented to the IRS in the original claims for refund. These claims were thus excluded from any calculation of Express Scripts’ refund for the years in question.

Implications for Tax Practitioners

The Express Scripts case underscores the critical distinction between the sale or licensing of software and the provision of services that utilize software for tax purposes under the former Section 199. Tax practitioners should carefully analyze the terms of agreements, the nature of customer access to software, and the fee structures involved when evaluating a client’s eligibility for the DPAD related to software. The court’s emphasis on the contractual language explicitly defining the nature of the transaction (service versus license) and the lack of direct customer access or separate fees for software usage provides valuable guidance in this area. This case serves as a reminder that the mere use of sophisticated software in the provision of a service does not automatically qualify the service provider for the DPAD as if they had disposed of the software itself.

Impact of Loper Bright Decision on the Court’s Analysis

The court’s application of the Loper Bright Enters. v. Raimondo, 144 S.Ct. 2244 (2024) decision to its analysis in the Express Scripts case is as follows:

Express Scripts argued that summary judgment must be denied because its software falls within 26 U.S.C. § 199(c)(5), citing Loper Bright. The court indicated that Express Scripts claimed that its software fell within 26 U.S.C. § 199(c)(5) (which defines “qualifying production property” to include “any computer software”) and that this fact, when considered in light of the Loper Bright decision, required the court to deny the government’s motion for summary judgment and grant Express Scripts’ request for relief.
However, the court stated that the determination of whether Express Scripts is entitled to a refund is not limited by Loper. The court explained that Loper did not affect an agency’s ability to exercise rulemaking authority clearly conferred by statute.
The court further elaborated on the principles derived from Loper Bright, noting that legislative delegation of authority within reasonable bounds is permitted and sometimes represents the best reading of statutory language. The Supreme Court in Loper Bright recognized that a statute’s meaning might authorize an agency to exercise a degree of discretion.
The court pointed out that Congress often enacts statutes that “empower an agency to prescribe rules to ‘fill up the details’ of a statutory scheme”, as mentioned in Loper Bright, 603 U.S. at 394-95.
Ultimately, the court stated that “when the best reading of a statute is that it delegates discretionary authority to an agency, the role of the reviewing court... is, as always, to independently interpret the statute and effectuate the will of Congress”, citing Loper Bright, 603 U.S. at 395. The court fulfills this role by recognizing constitutional delegations and ensuring the agency has engaged in reasoned decision-making within permissible boundaries.

In essence, the court used the Loper Bright decision to affirm its role in independently interpreting the tax statute (Section 199) and the IRS regulations related to it (specifically 26 C.F.R. § 1.199–3(i)(4)(i)(A) concerning the distinction between sales/licenses and services). The court asserted that its ability to analyze whether Express Scripts’ activities constituted a disposition of software (qualifying for DPAD) or the provision of services (not qualifying) was not restricted by Loper Bright. Instead, Loper Bright reinforced the principle that courts independently interpret statutes, even when agencies have rulemaking authority. This allowed the court to proceed with its analysis of the specific facts and contractual agreements in the Express Scripts case to determine if a "disposition" of software occurred under the meaning of Section 199 and its regulations.

Prepared with assistance from NotebookLM.