Relief In Celluloid

TIM JARVIS of Hammonds Suddard Edge looks at the tax breaks available for investors in British films.

IT IS NOT uncommon for high net worth individuals to be invited to make investments in British films. Typically these investments involve such individuals becoming partners in a partnership which acquires the master negative to a British film. This article overviews:

• the legal building blocks and the tax reliefs associated with an investment in a British film;
• the legislative changes introduced by Finance Act 2002;
• the structure of an investment made by a film leasing partnership;
• how a film leasing partnership might be affected by recent developments in case law; and
• how investments in films might be structured in the future.

Legal building blocks

The starting point to the tax reliefs associated with investment in British films is to define what is meant by a British film. The answer is provided by section 43(1)(c), Finance Act (No 2) 1992. This definition provides that a British film means a master negative of a film certified by the Secretary of State under Schedule 1 to the Films Act 1985 as a qualifying film. Under Schedule 1 to the Films Act 1985, a qualifying film will be one:

• where the producer was throughout the time the film was being made a person ordinarily resident in the European Union, or was a company registered in the European Union whose central management and control was throughout the time the film was being made exercised in the European Union;
• where the studios used in making the film were located in the United Kingdom; and
• the associated labour costs represent payments in respect of the labour or services of Commonwealth or European Union citizens.

This definition has, however, been narrowed by the Finance Act 2002 changes (see below).

Revenue expenditure

The next link in the chain is section 40A, Finance Act (No 2) 1992. This section deems expenditure on a British film to be revenue expenditure. Section 40A contains its own régime for when the expenditure on a British film is to be recognised for tax purposes which is not particularly tax favoured. It provides that the expenditure is to be recognised under two alternative methodologies. First, an income matching method may be used, the object of which is to write off the expenditure on the British film in proportion to the income of the film as it arises on a just and reasonable basis. This represents a statutory codification of the matching concept. Second, a cost recovery method may be used which allows expenditure to be written off pound for pound against income as it arises.

Three-year period

Section 42 provides an alternative structure for claiming relief for the expenditure to the two methodologies set out in section 40A. In essence, under section 42, provided that a person carries on a trade or business of exploiting British films and incurs revenue expenditure on the production or the acquisition of such a film, that person can claim relief for the expenditure over a three-year period. Where the claim is by reference to expenditure on the production of the master version of the British film, one third of the expenditure is given for the period of account in which the film is completed, and one third in each of the next two periods of account. Where expenditure is incurred on the acquisition of the master version of the British film, one third of the expenditure is relieved for the period of acquisition, with the balance written off over the next two periods of account. If the period of account in question is other than a period of 12 months, the expenditure is written off in the proportion that the period of account bears to 12 months.

Accelerated expenditure

The effect of section 42 is therefore to accelerate the recognition of revenue expenditure for tax purposes and to break the link between the recognition of expenditure and the generation of income from the British film.

The early recognition of revenue expenditure moves up a gear by virtue of section 48, Finance Act (No 2) 1997. This section amends section 42, Finance Act (No 2) 1992 as it applies to qualifying films completed on or after 2 July 1997, where the production expenditure on the film is £15 million or less. The relief is set to run for a fixed period and will not apply to films completed after 1 July 2005. Section 48 enables the person who produces the master version of a British film to deduct 100 per cent of the expenditure incurred in the production of the film in the period of account in which the film is completed. Alternatively, a person who acquires the master negative for a British film can deduct an amount equal to the lower of the production expenditure or the price paid for the master version in the period of account that the master version is acquired. The effect of section 48 is therefore to enable 100 per cent of the revenue expenditure incurred to be recognised upfront for tax purposes before the film starts to generate income.

The benefits of the acceleration of revenue expenditure under section 48 can be increased by injecting leverage into the structure. Typically, a marketed investment in a British film will be structured as a partnership. Under section 362, Taxes Act 1988, an individual can obtain a tax deduction for contributing money into a partnership by way of capital or premium where the money contributed is used wholly for the purposes of a trade, profession or vocation. Generally speaking, in order for the interest relief to be available, the partnership in question must not be a limited partnership or a limited liability partnership.

The accelerated revenue expenditure generated under section 48, Finance Act (No 2) 1997, as enhanced by leverage, can be used for a number of purposes. Under section 380, Taxes Act 1988, the revenue expenditure, to the extent that it exceeds the income derived from the film for that tax year with the consequence there is a loss, can be set off against all other sources of income from that tax year. In addition, any loss generated by the accelerated expenditure could be carried back and set off against income from the previous tax year under section 380. Further, to the extent that the relief has not been fully used, it may be possible to carry it forward to be set off against profits of the same trade in future tax years.

Capital losses

It should be also noted that any loss arising under section 380 can be converted into a capital loss under section 72, Finance Act 1991 and can be used to mitigate capital gains. The accelerated expenditure generated under section 48, Finance Act (No 2) 1992, which may be enhanced by leverage, can therefore be used for a number of purposes. An entrepreneur may have incurred a capital gain as a result of an exit, with the consequence that he may wish to turn the loss into a capital loss under section 72, Finance Act 1991 so as to mitigate the capital gain. However, care will need to be taken in such a strategy because the entrepreneur will be exchanging a capital gain (which will be charged to tax at an effective rate of ten per cent if full business asset taper relief is available) for a rental stream, which is chargeable to income tax at the rate of 40 per cent. It may therefore be necessary to couple this approach with an emigration strategy.

In structuring any investment in a British film, regard should be had to general company law and regulatory law concepts. If a partnership structure is to be used, the partnership may be an unlimited partnership. Therefore the investors will need to be advised about the risks of unlimited liability. In addition, it will be necessary to consider if the partnership is a collective investment scheme under the Financial Services and Markets Act 2000. If it is, it will be necessary to obtain specialist regulatory advice regarding the marketing of interests in the partnership.

Finance Act 2002 changes

Finance Act 2002 has introduced a number of changes, which are designed to combat perceived avoidance involving British films.

In order for a film now to qualify as a British film, it must be genuinely intended for theatrical release. For these purposes 'theatrical release' means exhibition to the paying public at a commercial cinema. The legislation goes on to provide that a film is not regarded as genuinely intended for theatrical release unless it is intended that a significant proportion of the earnings from the film should be obtained by such exhibition. The object behind this legislation is to exclude from the definition of a British film any films which are produced primarily for showing on television.

In addition, the legislation excludes deferred expenditure from the definition of production expenditure. Under the change, expenditure shall be taken not to include any amount that, at the time the film is completed, has not been paid and is not the subject of an unconditional obligation to pay within four months after the date of completion. The object behind this arrangement is to prevent an investor from being able to claim tax deductible revenue expenditure where the obligation to pay the revenue expenditure has merely been accrued as distinct from being physically paid.

Sale and leaseback structure

A common structure for investing in a British film is through a sale and leaseback structure. Under this type of arrangement, the film partnership will acquire the master negative from a film producer for a capital sum. The film partnership will then lease the negative back to the film producer in return for a rental stream. The partners in the film partnership are likely to have contributed a mixture of their own capital and debt finance to acquire their interests in the partnership. These partners will want to know that the rental stream will be sufficient to meet their obligations to their funders. It is therefore likely that the film producer will use a substantial portion of the sale proceeds to acquire a guarantee from a third party bank that it will meet its obligations in respect of the rents due under the film lease. The third party bank is likely to derive comfort that the film producer will not default on the rentals by virtue of the fact that the film producer is likely to have entered into pre-sale arrangements for the film to cinemas.

The object behind a sale and leaseback arrangement is to secure a tax deferral. In effect, the investor will be obtaining upfront the relief now in exchange for a taxable rental stream later. However, certain film partnerships are designed to go a step beyond this.

The investors in a film leasing partnership will wish to recognise upfront revenue expenditure for tax purposes under section 48, Finance Act (No 2) 1997. In order to be able to do this, the film partnership must be carrying on the trade or business of the exploitation of films. In Statement of Practice 1/98, the Revenue states that in order to satisfy this condition, the activities of the partnership must be on such a scale and organised in such a fashion that they do not constitute investment. A helpful case which can be used to demonstrate that the partnership satisfies this condition is Noddy Subsidiary Rights v Commissioners of Inland Revenue 43 TC 458. This case established that the grant of licences could constitute a trading activity in the appropriate circumstances.

Security

A key feature of the sales and leasebacks is the security which the film producer gives to the film partnership by virtue of the guarantee of the rentals given by the third party bank. It should be noted that section 225, Capital Allowances Act 2001, which reduces a lessor's entitlement to capital allowances on a sale and a finance leaseback where the lessor is protected from the risk of lessee default by virtue of third party guarantees, does not apply to this type of arrangement. This is because section 225 only operates to impose a restriction on capital allowances. It cannot, by its very nature, operate to deny a relief for revenue expenditure. In addition, the Revenue has considered this type of arrangement under Statement of Practice 1/98. The Revenue indicated that it would not challenge this type of arrangement so long as all the following conditions are met:

• the lessor, or any person connected with it, does not obtain as part of the arrangements a deposit of money or other collateral as security for the lessee's obligations under the lease;
• the third party guarantee must not generate any payments to the lessor unless the lease rental payments are not made because the lessee defaults on its obligations; and
• the lessor must not be involved in or otherwise influence the security negotiations between the lessee and the third party.

Draft statement of practice

Further, this year the Revenue circulated a draft statement of practice to supplement Statement of Practice 1/98 which has not, as yet, been implemented. The Revenue indicated that it would continue to apply the practice as set out in Statement of Practice 1/98, but that it would be reviewed in the light of cases before the courts.

In focussing on the direct tax effects of sale and leaseback structures, it is important not to forget the effects of other taxes such as VAT. Normally, VAT would be due on the sale of the film negative by the production company to the partnership and the partnership would be obliged to charge VAT on rentals paid to it by the production company. However, the film partnership will normally enter into a special arrangement with Customs by which it will invoice the production company for all the VAT on the rentals up front. This arrangement is designed to ensure that the film partnership can recover all of the VAT charged to it in respect of the sale of the master negative to it and is, also, designed to eliminate the risk to the film partnership of the lessee not paying VAT on the rental payments in the future.

The general thread of this article has been that the tax reliefs conferred by section 48, Finance Act (No 2) 1997 are designed to expedite the recognition of revenue expenditure. In effect, the investor opts to take this tax relief early with the consequence that the rents received in the future are fully taxable without any matching revenue expenditure. As one would expect, various structures have been put in place by certain partnerships which are designed to break this link and to ensure that the investor only gets deductible revenue expenditure without there being a matching revenue stream. These structures generally have one of the following characteristics at the inception of the partnership:

• a guaranteed sale of the interests in the partnership;
• arrangements for the early termination of the lease; or
• a pre-ordained plan to change the partnership into an incorporated body thereby limiting the responsibility to pay for the loan taken out by the partners to acquire their interest in the partnership.

The Revenue indicated that it would look critically at such arrangements in the, as yet, unimplemented draft statement of practice. Although the Revenue has not, as yet, adapted the draft statement, it is likely that the Revenue would adopt this approach in practice.

Case law

In advising on any sale and leaseback of a British film, it is important to consider the effects of Barclays Mercantile Business Finance Limited v Mason [2002] STC 1068. In very broad terms, the facts of this case involved a sale and finance leaseback of an oil pipeline where the lessor was a United Kingdom bank. Under the contractual documentation, the sums received by the original pipeline owner for the sale of the pipeline were effectively placed on deposit with the bank as security for the former pipeline owner's obligations to pay the lease rentals. Mr Justice Park held, applying the reasoning in MacNiven v Westmoreland Investments [2001] STC 237, that the bank had not genuinely incurred capital expenditure on the construction of the pipeline but had, in reality, invested in a structure of arrangements which were designed to return to it the initial capital outlay plus a profit. Accordingly, the bank's entitlement to capital allowances was restricted.

What then is the effect of Barclays Mercantile? It is possible to mount a strong argument that the case should be construed narrowly. This line of reasoning would stress as a key feature the fact that in Barclays Mercantile there was a circular flow of funds from the bank to the pipeline owner and back to the bank, whereas in a film financing there is merely a guarantee given from an independent third party to the lessor. If this narrow construction is adopted, then Barclays Mercantile would be regarded as entirely consistent with Statement of Practice 1/98, which indicates that arrangements under which the lessee puts a sum of money on deposit with the lessor are tainted, and would not be treated as creating new law. Nevertheless, it may be possible to derive broader interpretations from Barclays Mercantile, and it would be helpful if the Revenue would confirm that this decision does not apply in the context of film leasing arrangements.

Going forward

It may be that film partnerships going forward will start to make more direct involvement in films rather than entering into sale and leaseback arrangements.

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