US M&A Tax: What Are the Key Tax Strategy Considerations in Negotiating the Formation of a JV Partnership?

As more transactions involve Japanese and U.S. companies forming JVs, Section 704(c) applies to specially allocate depreciation expenses and gains or losses on the transfer of built-in gains and losses relating to contributed property under a specified method. The choice of allocation method affects the tax benefits and costs of both the Japanese and U.S. companies and directly influences the economics of the deal.

Section 704(c) provides three special allocation methods. Under the traditional method, book-value-based depreciation is allocated preferentially to the Japanese company, but even when fair value is higher, only the book value may be allocated. Under the traditional method with curative allocations, any shortfall in the allocation is offset by the U.S. company through measures such as reallocating deductions relating to the assets to the Japanese company.

Under the remedial allocation method, the Japanese company can receive the maximum amount of fair-value-based depreciation, while the U.S. company may recognize the shortfall in income as phantom income. The remedial allocation method is often assumed to be the method selected for amortization of intangible assets.

The election is generally made on the partnership’s tax return, with specific provisions included in the partnership agreement. When the U.S. company has greater negotiating leverage, the Japanese company may find it difficult to select the remedial allocation method.

The key point in negotiations is that, even after the contribution amount and ownership ratio have been determined, the allocation method can affect deal value. Accordingly, the Japanese company should clearly communicate at an early stage its deal value calculation based on the remedial allocation method.