Fundamental to the establishment of a joint venture is identifying the contributions that the parties will make to the venture. These contributions may be both tangible and intangible and the parties will have to agree on their respective valuations. The nature and value of these contributions will in turn be reflected in some manner in the degree of ownership of each of the parties in the joint venture. Further, while ownership will typically reflect each party’s financial interest in the venture, it also is likely to impact the degree of control over the venture by each party and the management structure through which that control will be exercised.
Capital Contributions
Subject to local law considerations, the parties’ contributions may be in a variety of forms, including cash, tangible property (including real property) know-how or other intellectual property, and other intangibles. In some cases, one or another of the parties will be contributing a going concern to be continued by the joint venture. The following questions should be considered with respect to capital contributions in connection with the proposed joint venture structure:
• Are there restrictions under local law on the percentage amount that can be owned by a non-resident?
• May a joint venture party’s share of profits be different from its share of assets on dissolution?
• May there be special allocations of profits to one or another party (including a preferred return to one party)?
• May a party’s voting percentage be different from its percentage interest in profits or asset distributions on dissolution?
• Are there any minimum capital requirements? Does a capital
contribution need to be registered with any governmental authorities?
• Are there any rules or restrictions on in-kind contributions
(e.g., contributions of assets necessary to conduct the business of the joint venture)? Is there a required ratio under local law of cash versus in-kind contributions? What type of valuation is required for in-kind contributions (e.g., by independent firm or governmental authorities)?
• How, and when, are in-kind contributions to be valued? Will one party conduct due diligence on in-kind contributions of the other party?
Will the contributing party give any representations and warranties with respect to assets being contributed?
• Are any third party consents or notices required for any in-kind contributions?
• If assets are being contributed and those assets are located in a separate jurisdiction, is a separate conveyancing document required under the laws of that jurisdiction?
• Are any transfer taxes or duties applicable to in-kind-contributions?
• Can the entity be capitalized through loans? Does local law regulate debt-to-equity levels? Are there any tax or other advantages to funding through debt rather than equity, or vice versa?
• Will the joint venture business require ongoing funding (e.g., for working capital, expansion)? If so, will each party be required to contribute to future calls for funding pro rata to its initial investment?
Will the commitment to fund be capped or open-ended? What should happen if any ongoing funding obligation is not met?
• What are the requirements for reducing capital (e.g., approval of commercial court)?
Ongoing Financing Needs
If a joint venture is sufficiently capitalized and is organized as a stand-alone entity, it may be able to obtain financing on its own to meet its ongoing operational needs.
Frequently, however, substantial financing will have to depend upon the support of the parties themselves, including in the form of additional capital contributions.
If the parties are to provide loan financing in addition to capital contributions, it should be determined at the outset. As an alternative, the parties may prefer to have the joint venture obtain financing locally but supported by the parties’
guarantee. Financial institutions will generally prefer that these guarantees be joint and several, that is, that each party be responsible for the full amount of any loans issued in reliance on the guarantees. On the other hand, if the parties have differing financial standing, this may as a practical matter more significantly expose the stronger party in the event that the joint venture fails. In a US joint venture between US and non-US parties, the US party or parties may feel more exposed simply because it will be easier for the financial institution to enforce the guarantee in the United States. In this case, the parties may wish to negotiate for several (and not joint) guarantees, under which each party is responsible only for its pro rata share of any financing of the venture.
Profit Distribution
In addition to planning for the financing needs of the joint venture, the parties also must address their plans with respect to profit distribution. As a threshold matter,
the parties should agree on whether, and to what extent, profits will be reinvested in the business of the joint venture. This goes to the parties’ overall goals for entering into the relationship and it should be assessed during the diligence phase. Beyond that, tax planning will be a crucial element for structuring the joint venture in a way that enables the parties to extract profits in an economically efficient manner.
The following questions should be considered in this regard:
• What are the rules for declaring dividends and distributing profits?
If the parties have developed a plan for the payment of dividends, does their plan conform to relevant local law? For example, are the parties free to determine when voluntary distributions can be made and by whom? Are there tax or regulatory constraints on the distribution of profits? Will it be necessary to establish a special structure for the effective distribution of profits (e.g., an income access structure)?
• Can distributions be made out of capital or only out of profits under local law? Are there requirements for mandatory reserves?
• Is it possible to provide for “special allocations” of profits (e.g., allocation of profits from one aspect of the business to one of the parties in a ratio different from the allocation of profits from another aspect of the business)?
Consolidation
Financial Accounting. Parties to a joint venture frequently need or at least want to be able to treat their interest in the venture on a consolidated basis for financial accounting purposes. The accounting rules relating to consolidation vary from country to country.
In the United States, it is ordinarily necessary for a party to a joint venture to
“control” the venture in order to consolidate under generally accepted accounting principles. Control is generally present where the party owns more than 50%
of the voting shares or equivalent equities in the joint venture. A more difficult situation arises where the ownership of the joint venture is split 50/50. Here, it is sometimes possible for a party to be considered in “control” by having the right to decide something of considerable importance without the agreement of the other party (e.g., the right to appoint or remove the majority of the board of directors or other governing body, or the power to direct their votes). The nuances of
determining whether control is present are beyond the scope of this handbook but it is vital that parties contemplating a venture take these issues into account as early as possible.
Consolidation is particularly important to a party contributing a business to the venture. If the contributing party can consolidate, it can report the financial results of the venture on a line-item-by-line-item basis. Thus, the party’s share of the sales, costs and earnings of the venture will be reported as part of the sales, costs and earnings of the party. If the results cannot be reported on a consolidated basis, only the net profit can be reported.
Tax. Separate from the analysis of consolidation for financial accounting purposes is whether the joint venture entity can be included in a consolidated income tax filing.
Subject to certain limitations, advantages of filing consolidated tax returns for US federal income tax purposes include the following:
• offsetting operating losses of the joint venture against the controlling party’s profits;
• offsetting capital losses of the joint venture against the controlling party’s capital gains;
• avoidance of tax on distributions from the joint venture to the controlling party;
• deferral of income on transactions between the joint venture and the controlling party; and
• use by the controlling party’s corporate group of the excess of the joint venture’s foreign tax credit over its limitation.
Disadvantages of filing consolidated tax returns for US federal income tax purposes include the following:
• deferral of losses on transactions between the controlling party and the joint venture;
• additional bookkeeping required to keep track of deferred transactions between the controlling party and the joint venture;
• possible elimination of foreign tax credits because of a lack of foreign income on the part of the joint venture; and
• possible accumulated earnings tax liability when the consolidated accumulated earnings and profits of the group exceed the minimum credit amount.
Internal Controls Over Financial Reporting
The Sarbanes-Oxley Act of 2002, together with its related regulatory reforms, significantly changed the corporate governance practices not only of US public companies, but also of non-US companies with securities that are listed, traded or otherwise registered in the United States. Often of particular concern in the joint venture context are the rules that require maintenance of internal control over financial reporting that conforms to US accounting and securities law standards.
In particular, Section 404 of the Sarbanes-Oxley Act requires each annual report of a public company to include a report by management on the company’s internal control over financial reporting. Section 404 also requires the company’s auditors to attest to, and report on, management’s assessment of the effectiveness of the company’s internal control over financial reporting. Careful diligence and on-going monitoring are typically necessary to assess the risk of a particular target or joint venture party with respect to Sarbanes-Oxley compliance.
Even in situations where the US company does not consolidate or otherwise control the joint venture vehicle, internal control issues still arise to varying degrees, depending on such factors as the level of the US company’s ownership, the materiality of the investment to the US company, and the level of control that the US company exerts. For example, where a US company is a minority partner in a joint venture, it may not need to expressly certify and obtain an audit report with respect to the internal controls of the joint venture, but it will need to do so with respect to its own financial statements and various line items which contain financial information with respect the joint venture. Accordingly, a joint venture party who is subject to the Sarbanes-Oxley Act will typically need to ensure that the joint venture maintains an appropriate level of internal control over financial reporting.