imMEDIAte MOVIES

Film Sale and Leaseback

Introduction

In 1997 the current Government introduced tax legislation designed to promote and build on the success of the British film industry. The new law introduced a 100% relief for both production and acquisition expenditure on British qualifying films costing less than £15 million.

The new legislation applies to production companies incurring expenditure on films in the course of their business, as well as other companies and individuals purchasing completed films for leasing purposes.

The 1997 Finance Act was followed in March 1998 by an Inland Revenue Statement of Practice which provided further guidance on the tax relief available and, most importantly, specified the Inland Revenue’s conditions for applying the legislation to film sale and leaseback transactions.

In his 1999 Budget speech, the Chancellor confirmed that the relief would be extended to cover film production expenditure until 2nd July 2002.

The film sale and leaseback business now provides an opportunity for individuals to share in the success of British films through a Government based initiative whilst at the same time taking advantage of :

  1. immediate tax benefits, and

  2. the security of a bank guarantee.

The following information explains:
  1. how the film sale and leaseback business works
  2. the requirements to be met for the tax relief to be available
  3. the benefits available to both film Producers and lessors
  4. the security available on film lease rentals.

EXECUTIVE SUMMARY

The following sections of this paper expand on certain key aspects of the Film Sale and Leaseback business and provide a more detailed explanation of the subject matter. This section summarises the key features of the business.

Nature of the Business

  • The purchase of completed British qualifying films and the grant of leases back to the Producers.

  • Film rentals payable under the leases are sufficient to repay capital and interest on bank borrowings up to the level of 90% of film purchase cost.

  • Film rentals are supported by a guarantee issued by an AA rated bank.

  • Film profit participation is available in addition to the secured nature of the lease rentals.

  • No commercial risk involved in the actual making of the films.

  • The 100% tax deduction available provides a cash flow advantage and an attractive return on capital.

  • The constitution of the Partnership and other safeguards, including special insurance cover, have been put in place to mitigate commercial risk.

Commercial Structure

  • The Partnership is resident in the UK for tax purposes and established under UK Partnership Law.

  • Partners borrow money to provide the majority of capital for film acquisitions.

  • Films are acquired from and leased back to sellers in return for a guaranteed escalating income stream, plus a share of film profits.

  • The guaranteed income stream is normally backed by a cash deposit with an AA rated bank and so continues even if the film is not successful or the film company becomes bankrupt.

  • The guaranteed income stream is sufficient to repay all of the partners borrowings and interest, and

  • imMEDIAte MOVIES acts as agent and secretary to the Partnership, sourcing films, legal services, and bank finance and providing all accounting and administration services in a manner that enables the Partners to retain day to day control of their business.

Taxation

  • Film sale and leaseback transactions lead to an immediate cash benefit for Partners.

  • A number of key conditions must be fulfilled for the relief to be available, the most prominent of which is that the Partnership must be trading.

  • The tax relief can be used not just to reduce income tax and capital gains tax liabilities of the current year but also of earlier years, and

  • The tax saving is repaid over the 10 to 15 year life of a film lease, i.e. the saving is a deferral or loan from the Inland Revenue.

Qualifying British Films

  • Films must be made by EEC based film makers.

  • 70% of production costs must be spent in the UK.

  • Production expenditure must not exceed £15,000,000.

  • Films may qualify under certain co-production agreements with overseas countries such as Canada and France.

  • Films must be certified by the Department of Culture, Media and Sport to provide proof of being British.

  • The film must be completed (i.e. in a state in which it can be distributed) prior to purchase by the Partnership, and

  • The price which the Partnership can pay for the film may be reduced if it has already been released, if all charges are not lifted, if certain presales have been made and if rights are not acquired as part of the sale and leaseback.

The Nature of the Business

Although film production companies can take advantage of the 100% write off of production costs, it is the fact that a purchaser of a completed film can also obtain the write off which has created the opportunity for film sale and leaseback transactions.

In its most simplistic form, a film sale and leaseback transaction involves the acquisition of the master negative of a film and the grant of a lease back to the Producer, in return for future film lease rentals.

The business of film sale and leaseback does, however, involve a series of purchases of "British Qualifying" films for payments which equate to the production cost of such films, and the grant of various leases to the Producers from whom the films were acquired. The leases are usually for a 15 year term with the film rentals escalating by 5% per annum throughout the term.

(ii) The film sale and leaseback business, therefore, provides an opportunity to participate in the success of a portfolio of films, whilst avoiding the commercial risks inherent in the actual making of a film.

The cash generative nature of the business, coupled with the ability to secure the capital invested, (see below) can provide the basis for an attractive return on capital even before account is taken of any share in a film’s profitability.

(iii) The tax effect of acquiring a "British Qualifying" film is to create an immediate deduction equal to the expenditure incurred on that film. This deduction can be offset against rentals subsequently receivable from the leasing of the film, or more particularly, can be offset against other income and capital gains of the current and previous years, providing the conduct of the sale and leaseback business constitutes a trading activity for tax purposes.

The availability of the 100% tax write-off allows film lessors to either reclaim tax previously paid, or reduce current year tax liabilities. Although the lease rentals arising in later years are fully taxable when received, the ability to reclaim tax in the first year, whilst only paying tax on rentals arising in subsequent years, produces an attractive cash flow advantage. The actual rate of return on any investment in the Sale and Leaseback business can only be determined by including the return on the cash generated by the tax saving.

(iv) To ensure that the sale and leaseback activity constitutes a trade for tax purposes, the business is usually conducted through a Partnership (in this case one established under UK law), so that the scale, organisation and number of transactions undertaken is greater than could ordinarily be performed by single individual.

    1. An important feature of the business is the nature of the security provided for the film rentals which arise under the lease. This security, which is arranged by the Producer, takes the form of a cash backed guarantee issued by an AA rated bank.

    2. The guaranteed lease rentals can be augmented through any profit participation negotiated at the time of the film acquisition and leaseback; any profit shares payable are not, however, covered by the bank guarantee.

    3. Whilst it is possible for an individual Partner to fully fund their share of Partnership capital from their own resources, up to 90% of the film purchase price is usually borrowed from a bank.

Importantly, the full amount of the bank loan and interest is repaid from the film rentals which are, in turn, supported by the bank guarantee.

(viii) Finally, certain day-to-day administrative responsibilities of the Partnership are devolved to the Partnership Secretary and Agent, imMEDIAte MOVIES.

Commercial Structure

The trading vehicle used for the business is a UK Partnership which, therefore, limits the number of Partners to twenty.

The following example shows the structure for a film sale and leaseback transaction where an individual Partner provides £1 million of Partnership capital to acquire a film:

The Partner provides his share of Partnership capital through a combination of his own resources and bank borrowings, in this case on a ratio of 10: 90.

The bank borrowings are fully recourse to the borrower but are backed by the film rental income, which is in turn guaranteed by an AA rated bank. Because the rental income is fixed, so too is the interest on the bank borrowings, thus allowing the film rentals to equate with the full amount of the loan and interest thereon.

Although it is the commercial terms of the film acquisition and leaseback which determine the maximum borrowings which can be fully serviced by the guaranteed lease rentals, past experience shows that approximately 90% of the total film cost can be provided through secured bank borrowings.

  1. Having obtained the necessary funding, the Partnership is now able to proceed with the acquisition of a completed "British Qualifying" film; the film is then leased back to the Producer from whom it was acquired. The commercial process involves, inter alia, legal due diligence, to ensure full title to the master negative in the film passes to the Partnership, and the negotiation of the film rentals, including any profit sharing or acquisition of distribution rights.

  2. In order to provide the necessary security for the film rentals, the Producer is usually required to deposit part of the purchase consideration with the guarantor bank, which in the above example represents £935,000 of the £1,000,000 film cost. It is this cash deposit which effectively allows the Producer’s bank to provide the guarantee which underpins the lease rentals.

    3. The Partnership has no involvement or influence over the consideration charged by the guarantor bank but can satisfy itself as to the quality of the guarantee; the Inland Revenue’s position on this issue is covered by the Statement of Practice (Ref. SP1/98) issued on 25 March 1998.

  3. The amount retained by the Producer to fund his business or next film is called the "net benefit" and is the subject of negotiation between the Partnership and the Producer.

From the "net benefit" the Producer is responsible for his own costs which may include legal, bank guarantee and introductory agents fees.

(v) In summary, the cash available, after deducting the "net benefit", is placed on deposit with an AA rated guarantor bank giving rise to interest which, together with the capital, is sufficient to guarantee payment of the lease rentals. The film rentals which are used to service the borrowing are therefore secure even if the film fails at the box office, or the Producer is declared bankrupt.

An illustrative example showing the above transactions in more detail is included at Appendix 1.

(vi) All decisions concerning the Partnership’s business are taken by the Partners as a whole. imMEDIAte MOVIES act as Partnership Secretary and Agent, carrying out day-to-day tasks including film sourcing and bank finance arrangements, managing the legal process and due diligence, as well as providing administration and accounting services.

Taxation

  1. The legislation surrounding film sale and leaseback is to be found in Section 48 F(2)A 1997. This legislation is supported by an Inland Revenue Statement of Practice. The purpose of the legislation is to provide a 100% tax deduction on the cost of production or acquisition of a "British Qualifying" film (see section 4). The availability of the 100% write-off is likely to give rise to a loss which can be off-set against other income and gains.

  2. For the tax loss to be available for offset against other income, the Partnership must be carrying on:

"a trade or business which consists of or includes the exploitation of master versions of films, etc. Persons considered to carry on such a trade will include those who produce films, whether directly or through the medium of an agent, and others acquiring films, including finance lessors, whose exploitation is on such a scale and so organised as to amount to trading rather than simply investment." (Inland Revenue Statement of Practice).

In summary, a Partnership engaged in film sale and leaseback transactions must be carrying on a trade as opposed to making investments. Although there is no precise judicial or statutory definition of what constitutes a "trade" or "trading", the issue has been the subject both of extensive case law and a Royal Commission.

Given the reference in the Inland Revenue Statement of Practice to, "such a scale and so organised", it is important that the Partnership’s

business includes a number of film acquisitions, and that the Partners play an active involvement in the business; the continuance of the business over a period of time, coupled with the scale of the operation

and the profit motive will all provide evidence to support the contention that the Partners are involved in a trading activity.

(iii) A trading loss, which has been established by a Partnership through the acquisition of British qualifying films, may be used in a number of ways by the Partners.

Partners may offset their share of the loss against:

    1. other income of the same and previous year;

    2. income of the previous three years (in the early years of trading); and

    3. capital gains of the same and previous year.

    4. Where a loan is taken out by a general (i.e., not limited) Partner to provide capital to a Partnership, relief is also available for interest charged on the loan.

    5. In order for these reliefs to be available, the trade must be carried on throughout the period on a commercial basis and in such a way that profits can reasonably be expected to arise within a reasonable time. In practice this means that leases are best structured to comply with details specified in the Inland Revenue Statement of Practice, i.e., lease rentals should increase by no more than 5% per year and should not include "balloon" payments at the end of the term.

    6. The tax benefit arising from the trade of film sale and leaseback is best illustrated by the following example which assumes £1,000,000 of Partnership capital to be applied towards the cost of a qualifying film, of which 90% is provided by way of a bank loan secured against future film lease rentals. The administrative costs associated with the purchase have been ignored in the example.

Example:

Production cash provided (£100,000)

Tax relief (£1m @40%) £400,000

Net cash benefit £300,000

The £1m deduction arising on the film acquisition creates a taxable loss which can, inter alia, be used to reclaim £400,000 of tax already paid on income or capital gains.

(vii) The lease rentals which are received annually over a period of 15 years represent taxable income for the Partners.

"British Qualifying" Films

The legislation governing the availability of the 100% tax write off on film expenditure applies only to "British Qualifying " films which cost less than £15m.

The original definition of a "British Qualifying" film was simplified with effect from July 1999. The following is a summary of the new rules:

    1. Nationality of the Maker:

      2. The film must be made by a company registered and centrally managed and controlled within the European Economic Area and certain associated countries.

    2. Studio/Locations/Production Costs:

      3. 70% of production expenditure must be spent on film making activity in the UK.

    3. Labour Cost:

70% of the total labour cost (excluding one person if wished) must be paid to citizens or residents of the EU, EEA or Commonwealth. Alternatively the above figure rises to 75% if two people are excluded.

Television drama and documentary programmes may also be included in the definition subject to certain restrictions such as the length of a series etc.

It is also possible for a film to qualify for certification as British as an official co-production, even if it does not meet the above requirements. The UK is party to a number of bilateral co-production agreements, including those with France, Germany and Canada.

A certificate from the Department of Culture, Media and Sport ("DCMS") provides evidence that a film has met these requirements. Such a certificate is issued following completion of the film.

Further conditions must be met to ensure the availability of the 100% tax deduction, namely:

    1. the film must be completed (i.e., in a state where it may be distributed and exhibited to the general public);

    2. not pre-sold to a significant number of territories;

iii not subject to earned/non returnable advances; and

iv not subject to bank charges at the immediate point of purchase.

If any of these conditions are not met, it is still possible to obtain the tax relief, but only by reference to the market value of the film at the point of acquisition, as opposed to the cost of the film.

 
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