SOVIET VENTURES REQUIRE CAREFUL STRUCTURING

Jeffrey A. Burt
Arnold & Porter
Washington, D.C.

When the Soviet Union first opened its doors to foreign investment in 1987, the only legal entity for housing foreign investment was the "joint venture" or "joint enterprise." Almost all foreign investments to date utilize this organizational form.

Initially, non-Soviet investors were limited to a 49% equity participation. In response to criticism from the West, that ceiling was lifted in 1988, and Western firms were presented with the option of producing almost all the equity in the joint venture--with attendant opportunity and risk.

Currently, there are in excess of 2,000 such joint ventures officially registered in the Soviet Union. It is important to note, however, that notwithstanding that substantial number, the average non-Soviet investment is relatively small; indeed, recent calculations indicate that the average non-Soviet investment remains under $2 million.

When the joint venture form came on the scene in 1987, Soviet proponents of a market economy dreamed that eventually the joint venture or joint enterprise would be deemed unnecessary. After all, in the United States as well as most other Western countries, there is no requirement to establish a special legal form to house foreign investment. Rather, Western investment is simply integrated into the domestic legal structure.

It was hoped that someday Soviet entities as well as foreign firms might be empowered to form their own legal vehicles for investing in the Soviet Union. In part, that dream has come true.

NEW STRUCTURES

Last year witnessed a major liberalization of the legal structure. Legal entities resembling those commonly found in the United States and Western Europe were approved (Fig. 1).

Thus, in mid-1990, joint stock companies were authorized, which envisioned publicly owned and traded companies with dividends and other rights normally associated with U.S. companies.

Soviet law also authorized what we in the United States call close corporations-corporations or societies with limited liability but whose shares are not publicly traded.

In the fall of 1990, President Mikhail Gorbachev, in the hopes of attracting more foreign investment, promulgated a decree permitting foreigners to own 1 00% of Soviet entities. What was interesting, and also typical, is that no implementing rules and regulations were issued. The procedures associated with this new legal form remain clouded.

Indeed, International Business Machines Corp. recently announced the formation of one of the first 100% owned Soviet enterprises for selling and servicing IBM equipment. Yet there are no procedures in place for these purposes. We understand that IBM forwarded to Soviet authorities the rules it relied upon in forming such an entity in Czechoslovakia, suggesting that they serve as the model in the Soviet Union.

Two other legal entities are available to facilitate Western efforts to establish a presence in the U.S.S.R.

For many years, Western firms established representative accredited offices to help promote sales and other operations in the Soviet Union. Accreditation entitled a Western firm to occupy an office and to house an expatriate in Moscow.

During the last several years, a number of Western firms have bypassed accreditation procedures and simply rented hotel rooms or found space to promote their interests. These unaccredited offices have burgeoned; new regulations have been issued requiring unaccredited representatives to register with local authorities.

ASSERTIONS OF AUTONOMY

Assertions of autonomy by the various Soviet republics complicate the challenges of investing in the U.S.S.R. They are among political forces unleashed by democratic elections held in 1990, the first in 70 years.

The Russian Federation, by virtue of its size and dominance, assumed particular importance in this effort. Late in 1990, it began passing its own laws designed to promote a more rapid transition to a market economy.

The Russian Federation also took the position that its laws prevailed over those adopted at the all union level. The "war of laws" or "war of jurisdictions" adds an element of uncertainty in the current investment climate. In late 1990, the Russian Parliament adopted legal forms commonly accepted in the West (Fig. 2).

Arnold & Porter helped the Russian Federation in drafting the 23 laws that became the basis for the 500 day transition plan to a market economy. Conservative elements within Soviet society now refer to that 500 day plan as the "500 awful nights."

GOALS DIFFER

Whatever the legal form and jurisdiction, companies should recognize that the Soviets' goals may differ from their own and that deals may become impossible.

Monsanto Co., for example, signed a letter of intent late in 1986 to process and sell its Roundup herbicide in the Soviet Union.

To Monsanto, the deal seemed to benefit the Soviets by providing them a desperately needed product, by increasing crop yields and thereby reducing grain imports, and by providing access to world-class agricultural technology and management systems. Monsanto hoped to avoid construction of a full-scale manufacturing facility. It wanted to import intermediate products from the West and allow the Soviets to manufacture the end product in an existing dedicated chemical plant. The Soviets wanted something quite different from the joint venture: the chance to export Roundup to the West and earn hard currency. They wanted to build a full-scale, full-cycle plant and avoid importing raw materials, intermediate products, or anything requiring expenditure of hard currency.

Monsanto assessed the project in terms of its broad effects on the Soviet economy; it had no desire to export Roundup to Western markets, which received adequate supplies from existing plants. The Soviets took the narrow approach; they wanted to boost exports and earn hard currency.

The conflict kept Monsanto's proposal from advancing beyond the letter of intent stage. It has come up in many other joint venture negotiations and must be resolved before the ambitious plans spelled out in letters of intent ever become reality.

TAXES COMPLICATED

Because all these legal forms for housing foreign investment are quite new, tax treatment of foreign investment in the Soviet Union, ambiguous prior to recent reforms, is more complicated than ever (Fig. 3).

A 45% corporate income tax is generally imposed on Soviet entities. That rate was reduced to 35% by a Mar. 22, 1991, presidential decree published in Izvestia on Mar. 25, 1991. Joint ventures and certain other legal forms with 30% or more foreign participation enjoy a preferential tax rate of 30%. Repatriation of profits entails an additional 15% tax.

When market initiatives began in 1987, these two taxes were the only ones of concern to prospective non-Soviet investors. Unfortunately, however, as the Soviet Union and its republics lurch toward capitalism they have become tax-hungry.

Two additional taxes in 1990 are of particular concern. One is an excess profits tax. With respect to state enterprises with no foreign participation, a 100% profit tax is imposed once an enterprise exceeds certain profit percentages established on an industry by industry basis.

For joint ventures with foreign participation, the excess profits tax is not as confiscatory but does have to be carefully scrutinized depending on the industry.

The Russian Federation enacted a somewhat more lenient version of the excess profits tax geared to the cost of production. Again, rules remain unclear.

The Soviets also promulgated a series of export taxes in early 1991. The oil industry was hit particularly hard. A 40% export tax was initially imposed on all Soviet entities, including joint ventures.

The tax was imposed to assist in financing domestic investment. An unintended side effect was to derail Western ventures whose returns on investment were tied to the export of crude oil.

At least temporarily, that export tax has now been reduced to 10%. However, the only authoritative document we have seen omits reference to joint ventures. These export taxes are to be adjusted on a year by year basis, and their introduction has added a new level of uncertainty to oil and gas investments.

This export tax can be paid in rubles. At present resourceful joint ventures can convert dollar earnings into rubles at very favorable exchange rates. This effectively reduces the tax but whether this will continue depends on a series of factors, including new laws regarding hard currency and ruble convertibility.

LEGAL QUESTIONS

Further uncertainty arises from the immaturity of the Soviet legal system.

A personal experience illustrates the point. In 1986 I presented a 2 day seminar in Moscow on joint ventures to about 80 Soviet officials, some of whom were involved in joint venture legislation being drafted at the time.

Someone in the audience raised an interesting question about proceeds from liquidation of a hypothetical, successful 5 year old U.S.-Soviet joint venture. The assumptions were that each party had contributed $100,000 and that the current value of the venture is $2 million. How much should the U.S. partner receive upon liquidation?

To the U.S. way of thinking, the answer seems obvious: $1 million. To the Soviets, however, this represents an unjustifiable windfall--10 times the original investment. The Soviets are comfortable with an 11-12% return on Western investment. Hence the question.

Three months after the seminar, the Soviets published new joint venture guidelines, Article 52 of which specifies that upon liquidation, the foreign partner has the right to return its contribution in money or in kind pro rata to the "residual balance value" of its contribution at the moment of liquidation, after discharge of obligations to Soviet partners and third parties.

What's "residual balance value?" Is it the original investment, the investment's current value, or some other formulation? The legislation doesn't say.

Each joint venture must answer questions like this case by case. This needn't discourage non-Soviet investors; the Soviets have proved to be receptive to reasonable and imaginative proposals on issues such as these. They have considered algebraic formulas defining liquidation values and accepted Western concepts of book value and multiple of earnings. And non-Soviet partners can subject issues like this to a tribunal of experts when joint ventures terminate.

What's important is that joint venture participants not rely on ambiguous language of current legislation to resolve such an important matter. Parties to a joint venture must negotiate and document many legal and business issues that would be considered standard in a country with an established legal framework.

Partners must establish a basic framework that provides for corporate governance. They must define in detail the amount, form, and valuation of equity contributions and resolve complex tax issues. In the Soviet Union they can request the Ministry of Finance to provide special tax concessions.

Negotiations also should include procurement arrangements; in a planned economy ready access to raw materials or products cannot be assumed. They also can include direct importation privileges, repatriation of profits, safeguarding real and intellectual property rights, changes in U.S. export controls that adversely affect operations, distribution responsibilities, termination events and rights, auditing and reporting procedures, accounting issues, trade unions and labor relations, and operational matters peculiar to economies new to free market principles.

CONCLUSIONS

What conclusions can be drawn from these recent legal and tax developments in the U.S.S.R.?

First, there will be greater choice for Western investment. Second, the Soviet Union's legal and financial environment continues in turmoil and uncertainty.

Investors will have to do their best to minimize risks. Indeed, they may find it advantageous to resist official encouragement to form a joint venture or other legal entity in the Soviet Union. Straight contractual relationships may avoid some of these problems.

There is a premium on imagination. One recent Soviet joint venture, which was in the manufacturing field, illustrates this point: Soviets and foreign founders set up two joint ventures. One undertook certain activities in the Soviet Union, and the other was incorporated abroad.

The two joint ventures then entered into a variety of contractual relationships involving joint development and production.

Sales in foreign markets for hard currency originated abroad. Sales in the domestic market originated from the joint venture established in the U.S.S.R. (Fig. 4).

Careful structuring of investments, utilizing new legal entities or more traditional contractual undertakings, may serve to alleviate some of the concerns of U.S. investors who want to do business in the Soviet Union but are concerned about the shifting judicial and political landscape.

Copyright 1991 Oil & Gas Journal. All Rights Reserved.