By Josh Ye, Julie Zhu and Kane Wu

HONG KONG (Reuters) -Unity Software Inc, the U.S. developer best known for software used to design video games, is in talks to spin off its China unit to help it expand in the world's biggest games market, four people with knowledge of the matter told Reuters.

San Francisco-based Unity has sought strategic investors to join it in a business valued at over $1 billion during talks, said two of the people, declining to be identified as they were not authorised to speak publicly on the matter.

Unity declined to comment. Its share price closed up over 5% on the news on Tuesday.

The talks come as strained Sino-U.S. relations exacerbate sensitivities over technology transfer and data handling across borders, prompting tech firms to reappraise their operations in China. At the same time, there is growing interest in expanding game-making software to new technologies such as the so-called metaverse, an immersive three-dimensional internet.

Unity entered China in 2012 and its eponymous software, known as a game engine, powers many of the country's most popular games such as Honor of Kings from gaming leader Tencent Holdings Ltd and miHoYo's Genshin Impact.

Rivals include Tencent-backed Epic Games, the U.S. developer of the increasingly popular Unreal Engine 5.

Unity's spin-off plan is being driven by a desire to see its software used more extensively in China in areas as varied as smart city modelling to industrial design, as well as in the metaverse, two of the people said. Potential investors Unity has been speaking to have made big bets on the metaverse, they said.

With China tightening data handling regulation, Unity believes a spin-off would aid this expansion as it would give the unit more local ownership and autonomy over how it operates in the country, which could also increase its attraction to local government and state-owned partners, the people said.

The spin-off would be one of China's bigger technology deals this year as investment activity has slowed due to weak economic growth, COVID-19 outbreaks and regulatory tightening.

Unity China Chief Executive Zhang Junbo has been working on the plan for at least a year, two of the people said. Progress has been further slowed by Unity's share price sinking 80% since its November 2021 high amid weakness in U.S. tech stocks, and by a product missing performance expectations, they said.

Zhang disclosed Unity's China expansion ambition last month to local tech media outlet 36Kr without mentioning a spin-off, saying Unity was exploring ways to make its technology safe and controllable within China - a reference to the government's mandate for important technology to be controlled domestically.

He also said Unity would likely hire over a thousand engineers in coming years while expanding offices in Beijing and Guangzhou in addition to its main office in Shanghai.

Two of the people said Unity's Shanghai-based employees have been asked to sign contracts with the new entity, and that talks about an operating budget separate to its parent's are ongoing.

A local joint venture (JV) could help Unity gain a footing with sensitive industries such as governments and manufacturing that are seeking to modernise their operations with digital twins and real-time 3D enabled technologies, said Matthew Kanterman, director of research at Ball Metaverse Research Partners.

While forming a China JV carries risk - a notable example being a dispute between British chipmaker Arm and its Chinese unit - Kanterman said such JVs have worked well for many Western tech firms, such as HP Inc and Nokia Oyj.

Having the right local partners can help Unity succeed where others struggle, Kanterman said.

(Reporting by Josh Ye, Julie Zhu and Kane Wu in Hong Kong; Additional reporting by Josh Horwitz in Shanghai; Editing by Brenda Goh and Christopher Cushing)