Recent letter ruling aids foreign joint venture.

U.S. companies continue forming strategic alliances to gain access to new markets and achieve cost savings. It should be noted that joint ventures with foreign companies contain potential traps.

Under pre-Taxpayer Relief Act of 1997 (TRA '97) rules, Sec. 1441 applied a 35% excise tax to the gain inherent in property transferred to a foreign partnership. A taxpayer could elect to treat the transfer as a sale or exchange subject to income tax rather than the excise tax.

Under the TRA '97, the 35% excise tax has been repealed. Now, under Sec. 367, a transfer to a foreign partnership will be treated as a sale or exchange equal to the fair market value of the transferred property; thus, the transferor must recognize gain. This revision was effective for transfers occurring after Aug. 5, 1997.

Despite the legislative changes, U.S. companies will continue to form international joint ventures. The IRS recently issued Letter Ruling 9741037, which may be important to U.S.-based taxpayers forming joint ventures with foreign-based companies.

Although the ruling deals with transfers to a foreign partnership under the pre-TRA '97 rules, the ruling is equally applicable under the TRA '97 amendments.

The ruling deals with a domestic and foreign group forming a joint venture under the following steps:

1. Domestic joint venture partner's organization structure:

[ILLUSTRATION OMITTED]

2. The Foreign joint venture partner's organization structure:

[ILLUSTRATION OMITTED]

The U.S. Parent and FP have agreed to combine their respective B operations into a worldwide joint venture to develop, manufacture and market B products. The combination proceeded along the following steps:

1. The subsidiaries of the foreign joint venture partner organized of a foreign joint venture.

[ILLUSTRATION OMITTED] 2. JV Foreign is set up as a Delaware limited liability company (LLC), changes its name to JV Domestic and elects to be treated as a partnership for U.S. tax purposes. This transition will not disturb the entity's status as a foreign corporation.

[ILLUSTRATION OMITTED]

3. The U.S. parent will incorporate its business into DS-2, and DS-1 and DS-2 will form a U.S. partnership via a U.S. LLC (Target LLC).

[ILLUSTRATION OMITTED]

4. Target LLC will merge into JV Domestic; CFC-1 will contribute CFC-2 in exchange for an interest in JV Domestic, FS-2 will transfer its interest in JV Domestic to FS-1 and withdraw and DS-1 will transfer its interest in JV Domestic to DS-2 and withdraw.

[ILLUSTRATION OMITTED]

5. The resulting structure will be as follows:

[ILLUSTRATION OMITTED]

Based on the above series of steps, the merger of Target LLC into JV Domestic will not result in a transfer of property to a foreign partnership. Thus, the formation of the joint venture structure was accomplished free of the pre-TRA '97 excise tax. This structure would also appear to avoid the TRA '97 income tax. This is an important ruling to consider when U.S. multinationals form an international joint venture with a foreign partner.

From Bill Zink, CPA, Chicago, Ill.