I have been following this thread, and while I am pretty new I decided to
play with this problem as a learning experience.  I created the following
modules, which are slightly different from your code, which compile and do
not generate any warnings or errors.  I think the main change I made was to
use CommonFilesFolder in the perUser.  I did this because the msdn link in
this thread indicates that it will switch locations for ALLUSERS and I
always got errors using LocalAppDataFolder.  I do not have a test box handy
so I may be on a rabbit trial and have something that compiles but does not
do what you want.

MSM.wxs
-----------------------------------------------------------------------------------------
<?xml version="1.0" encoding="UTF-8"?>
<Wix xmlns="http://schemas.microsoft.com/wix/2006/wi";>
        <Module Id="MSM" Language="1033" Version="1.0.0.0">
                <Package Id="a60c4f05-c2b2-4cb8-baab-b8d37320fea8" 
Manufacturer="test"
InstallerVersion="200" />

    <Directory Id="TARGETDIR" Name="SourceDir">
      <Directory Id="MergeRedirectFolder">
        <Component Id="MsmComponent"
Guid="{49CD0F4B-A744-41A7-85E2-09B71B4C7FD6}">
          <File Id="MsmComponent.File" KeyPath="no"
Source="C:\Windows\notepad.exe"/>
          
          <RegistryKey Root="HKMU" Key="SOFTWARE\test\keypath">
            <RegistryValue Name="MsmComponent.File" Value="1" Type="integer"
KeyPath="yes" />
          </RegistryKey>
          <RemoveFolder Id="DelMergeRedirectFolder" On="uninstall"/>
        </Component>
      </Directory>
    </Directory>
        </Module>
</Wix>

MachineMSI.wix
----------------------------------------------------------------------------------------------------
<?xml version="1.0" encoding="UTF-8"?>
<Wix xmlns="http://schemas.microsoft.com/wix/2006/wi";>
        <Product Id="*" Name="MachineMSI" Language="1033" Version="1.0.0.0"
Manufacturer="Company" UpgradeCode="a3b63a3c-6a71-4e07-b061-2c1be70b2f5e">
                <Package InstallerVersion="200" Compressed="yes" 
InstallScope="perMachine"
/>

                <MajorUpgrade DowngradeErrorMessage="A newer version of 
[ProductName] is
already installed." />
                <MediaTemplate />

                <Feature Id="ProductFeature" Title="MachineMSI" Level="1">
      <MergeRef Id="MSM"/>
    </Feature>
        </Product>

        <Fragment>
    <Directory Id="TARGETDIR" Name="SourceDir">
      <Directory Id="CommonFilesFolder">
        <Directory Id="INSTALL_FOLDER" Name="Company">
          <Merge Id=&quot;MSM&quot; SourceFile=&quot;&lt;path to
msm>\msm.msm" DiskId="1" Language="1033"/>
        </Directory>
      </Directory>
    </Directory>
        </Fragment>

</Wix>

UserMSI.wxs
--------------------------------------------------------------------------------------------------
<?xml version="1.0" encoding="UTF-8"?>
<Wix xmlns="http://schemas.microsoft.com/wix/2006/wi";>
        <Product Id="*" Name="UserMsi" Language="1033" Version="1.0.0.0"
Manufacturer="Company" UpgradeCode="924f8f16-3f9a-4724-8811-6044e92018ad">
                <Package InstallerVersion="200" Compressed="yes" 
InstallScope="perUser" />

                <MajorUpgrade DowngradeErrorMessage="A newer version of 
[ProductName] is
already installed." />
                <MediaTemplate />

                <Feature Id="ProductFeature" Title="UserMsi" Level="1">
      <MergeRef Id="MSM"/>
                </Feature>
        </Product>

        <Fragment>
    <Directory Id="TARGETDIR" Name="SourceDir">
      <Directory Id="CommonFilesFolder">
        <Directory Id="INSTALL_FOLDER" Name="Company">
          <Merge Id=&quot;MSM&quot; SourceFile=&quot;&lt;path to
msm>\msm.msm" DiskId="1" Language="1033"/>
        </Directory>
      </Directory>
    </Directory>
 </Fragment>

  <Fragment>
    <DirectoryRef Id="INSTALL_FOLDER">
      <Component Id="removeINSTALL_FOLDER">
        <RemoveFolder Id="removeINSTALL_FOLDER" Directory="INSTALL_FOLDER"
On="uninstall"/>
      </Component>
    </DirectoryRef>
  </Fragment>
</Wix>

I hope this helps.  Please let me know if I should have done something
different.
Phill



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