Fujitsu Ltd, Panasonic Corp and Japan's government-backed Innovation Network Corp, an investment fund, would also be part of the deal, which could outsource production to privately held chip maker GlobalFoundries, sources familiar with the matter said.

Japan's once high-flying chip sector has been forced into a series of mergers and restructuring drives over the past decade to keep up with aggressive competitors in the United States, South Korea and Taiwan, led by Intel Corp and Samsung Electronics.

Under the latest plan, the new company will develop system chips, which serve as the brains of electronic gadgets and automobiles, but outsource production.

The move would revamp a money-losing division for Renesas, a market leader in system chips by sales ahead of Intel and Broadcom Corp, and allow Panasonic and Fujitsu to focus on more profitable businesses.

"This is just one of many options under consideration," one of the sources said, adding that other areas of the chip sector were also under discussion and there could be further twists and turns as talks proceed.

As part of the deal, the sources said California-based GlobalFoundries could also buy cash-strapped Elpida Memory's chip production plant in Hiroshima, while the Nikkei business daily said Elpida, which has been battered by a strong yen and tumbling memory chip prices, would move its DRAM chip production to Taiwan.

The news sparked a surge in chipmaker shares, with Renesas jumping as much as 14 percent to a three-month high of 576 yen and Elpida climbing to an intraday high of 374 yen, up nearly 10 percent. Fujitsu rose 5 percent to 399 yen.

"The first observation is that it looks good for every company -- Elpida, Fujitsu, Panasonic and Renesas," said Yasuo Sakuma, portfolio manager at Bayview Asset Management.

But he remained skeptical.

"It's like the bad parts of a banana, apple and orange getting put together in a mixer to make juice. If you drink that it may taste good the first time. But the juice will go bad in a couple of days."

BAD JUICE?

Renesas, Fujitsu and Panasonic said separately that no decisions had been taken regarding their chip businesses, while Elpida said the report on the sale of the Hiroshima plant was incorrect, but gave no details.

The Nikkei said the three companies were expected to hammer out a basic agreement by the end of March and would aim to set up a new company by the end of this year. But one of the sources suggested the time frame was too ambitious, especially given that various options were under review.

Haruo Sato, senior analyst at Tokai-Tokyo Securities, saw potential snags to an agreement.

"The top management of the three companies would have to reach agreements on tough issues such as allocation of resources, including job cuts. I think it will be extremely hard for them to reach a compromise," he said.

The Japanese government is wary of allowing technology know-how to disappear overseas and used its Innovation Network fund in a similar move last year, announcing plans to merge the small to medium sized liquid crystal display (LCD) panel operations of three firms into a new company.

Japanese chipmakers have been hit hard over the past year by a sluggish economy and a strong yen, with many falling into the red on an operating basis.

Renesas, itself the product of successive mergers of the chip divisions of Hitachi, Mitsubishi Electric and NEC Corp, reported an operating loss of 33.2 billion yen ($430 million) for the nine months to December 31.

Elpida, set up to take over the struggling DRAM operations of several Japanese chipmakers a decade ago and now scrambling to meet debt repayment deadlines in late March and early April, last week posted a wider-than-expected 43.8 billion yen operating loss for the October-December quarter.

Speculation has swirled that Elpida was seeking a rescue deal with U.S. DRAM maker Micron Technology and its Taiwanese technology partner, Nanya Technology, although Elpida President Yukio Sakamoto has played down the need for an immediate equity tie-up.

Japanese chip industry leader Toshiba which has largely remained above the merger fray in recent years, cut its full-year operating profit forecast by one-third to 200 billion yen after posting a 72 percent drop in third-quarter profit.

($1 = 76.95 yen)

(Additional reporting by Nobuhiro Kubo, Miki Kayaoka, Dominic Lau, Emi Emoto and Chikafumi Hodo in Tokyo; Writing by Edmund Klamann, Editing by Richard Pullin)

• A Permanent Economic Emergency