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The new Tax Relief system for British films offers
producers up to 20% of their budget in cash. The system replaces
Section 42 and 48 which offered a tax break of up to 40% and also
introduces a host of quite complex new clauses to limit and define which films are
eligible for relief. Love it or hate it, it
is a piece of legislation which will effect not just which films get
made in the UK in the coming years, but exactly how those films are
packaged and produced to ensure they can make the most of the possible
benefits.
The new Finance Act runs to several hundred pages, which Adam P Davies,
co-author of Netribution's Film Finance Handbook,
has sifted through to write a comprehensive and
detailed 5 page guide to the new tax relief and system in
the UK - with glossary and worked examples. We can't promise
we've interpreted it all correctly, but it has been looked over by the
UK
Treasury.
IT'S NEW, AND IT'S HERE
So the new UK film tax incentives have finally arrived. Those of you who have read the 2005/06 UK Film Finance Handbook
will know that they've been a long time coming; the original official
announcement about the impending demise of "Sections 48 and 42" (the
old system), and the introduction of a new "20% tax credit" ,
was first made in the Spring of 2004. The British Government, at that
time, was becoming increasingly disillusioned with various alleged
"abuses" of the incumbent system, and the fact that investors and
so-called "middlemen" were apparently creaming much of the benefits
intended for producers.
So the idea was to replace those tax
incentives, and the sale & leaseback mini-industry that they had
spawned, with a new tax "relief" system, centred around a so-called
enhanced deduction and tax credit , targeted solely for the benefit of
producers.
"producers will receive an additional tax deduction of up to 80% of
qualifying expenditure, amounting to a net benefit to the producer of
up to 20% of qualifying production costs "
As pointed out in the Handbook,
the Government's initial proposals were littered with flaws and
problems, and would never have provided the producers with the headline
"20% benefit" that had been promised. But since then, various consultation processes and revisions to the outline
proposals have finally resulted in draft legislation that, if passed by
Parliament in summer 2006 and cleared by the European Commission under
their State Aid requirements, should provide for a much more reasonable
set of regulations. The Finance Bill (No.2) 2006 ("the Finance
Bill"), published on 7 April 2006, sets out for the first time the
proposed legislation in detail and, despite still not quite providing
the producer with the full 20% towards financing his/her budget, has
broadly been welcomed by most of the industry. There are still,
however, a number of issues that urgently require clarification where
detail is still missing from the draft legislation and accompanying
FAQs (which appear to have been published in place of formal Guidance
Notes or Statements of Practice).
Incoming are two fundamental
differences from the previous regime. First, a change to the
qualification criteria for a "British Film", and second, a change to
the tax incentives available to those films that do qualify. The
"headline" for the new system is that producers will receive an
additional tax deduction of up to 80% of qualifying expenditure,
amounting to a net benefit to the producer of up to 20% of qualifying
production costs (For larger budget films - over £20m - the additional
deduction is reduced by a further 20%, giving a maximum net benefit of
16%). The phrases used in this description are not necessarily familiar
to the lay reader, and the aim of this Guide is to explain the new
rules in simple, straightforward terms, illustrating who will benefit,
what will (or won't) qualify under the rules, and how they will be
implemented. The analysis includes a few numerical examples, and is
followed by a Glossary of terms introduced by the draft legislation.
The
new tax relief is split into two parts, a basic treatment and the
special film relief . The basic treatment covers the new accounting
rules dealing with films generally, putting film investment on a
"revenue" (rather than capital) basis, explaining how income is
calculated, and setting out what can and can't be included as
legitimate expenses (see "SCHEDULE FOUR AND THE BASIC TREATMENT",
below). The special film relief - which we'll look at first - is the
"extra bit", the specific film incentive we've waited so long to hear
about. It gives two options, either an enhancement of allowable
expenses to set against profits, or a tax credit.
WHO GETS THE BENEFIT?
The Producer
The legal person entitled to the new benefits is the producer, or
more specifically, the film production company (or " FPC "). This is
the company responsible - and actively engaged in the planning and
decision making - for the pre-production, principal photography and
post-production (these being the core production activities ) of the
film. The FPC must directly negotiate, contract and pay for rights,
goods and services required for the production, and so will normally be
the producer's regular production company, or a special company set up
solely for the purpose of producing the relevant film. It doesn't have
to deal with all the rights, or even all the negotiations, so it is
quite feasible for (say) a studio parent to negotiate various terms on
its behalf. Note that there is no requirement for the ownership of the
master negative or copyright. There can't be more than one FPC per film
(although there could be none) so, in the event of more than one
possible company, it will be the one ultimately "most responsible" for
the core production activities.
In an official co-production, the
FPC will be the UK co-producer, assuming it's not contributing just
finance to the film. There are no provisions referring to the taxation
of individuals or partnerships that produce films, and so they won't
benefit from the new tax treatments. For certainty, therefore, it is
imperative always to produce through a limited company (FPC).
HOW DOES A FILM QUALIFY?
The
special film relief is available for any film that satisfies four
separate conditions. It must (i) be intended for theatrical release,
(ii) qualify as a "British Film" under the amended Schedule 1 of the
Films Act 1985, (iii) have the requisite amount of UK incurred core
expenditure, and (iv) commence principal photography on or after 1
April 2006. For these purposes, as in previous legislation, the
definition of a film includes the soundtrack to it. We'll now look at
each of the four conditions in turn.
"This condition would
have ruled out award winning films such as Gods and Monsters and Mrs
Brown"
(i) "A film intended for theatrical release..."
This
means exhibition to the paying public in a commercial cinema with a
view thereby to earning a significant proportion of the film's total
income. Theatrical release must be the FPC's intention from the outset,
when the film-making activities begin (this means at the start of
development! - see below), rather than at completion (as was the case
under previous legislation). Accordingly, a film that is initially
commissioned for TV will not qualify even if, during production, it is
decided to "promote" it to a theatrical release. This condition would
have ruled out award winning films such as Gods and Monsters and Mrs
Brown which, although successful at the box office, were initially
commissioned for television. Conversely, if a film does not ultimately
end up in the cinemas, despite initial intentions that it should, it
will still meet this qualification condition. Quite how one
demonstrates this "intent", and whether the tax authorities will
believe it, is somewhat open to question. Note that a series of films
constituting a self-contained work (or series of common-themed
documentaries) with a total playing time of under 26 hours, and with
less than 26 episodes, is treated as a single film, but as it must be
intended for theatrical release, this would rule out television series.
(ii) "...which qualifies as a British Film,..."
This
part of the new legislation has been published separately to the
Finance Bill, in The Films (Definition of "British Film") Order 2006
which was made on 31 March 2006, and came into force the next day . It
modifies the old Schedule 1 to the Films Act 1985, which sets out the
qualification criteria for a "British Film". The FPC will need to
present the tax authorities with a certificate of qualification from
the Government's Department of Culture, Media and Sport ("DCMS"), which
administers the application process and grants the certificates. To
qualify as a British Film, the legislation will provide for a two-tier
test.
First, there is a new points-based "Cultural Test"
similar to (but somewhat more complicated than) that of the European
Convention on Cinematic Co-Productions. And second, the original
"archive footage" test still will apply (having not been modified by
the new regulations). Taking the two parts in turn...
The Cultural Test
Under
the new Cultural Test, the film itself will have to score at least 16
points out of a possible 32. To score a point, the relevant element of
the film typically has to be British . As you will see, the
administrative burden on producers wishing to demonstrate the
"Britishness" of their films is going to be fairly substantial!
Although not overly apparent from the legislation itself, the DCMS has
split the Cultural Test into three sections:
Section A of the
points system provides for a possible four points to be given for
cultural content . One point is given for the setting of the story
(must be over 50% of the pages of the script). A fictionalised version
of the UK will count, but not a generic fictional setting. One point is
given if at least one of the three principal characters (according to
centrality and prominence to the story) is British. Another point is
given if either the subject matter (the story, characters, events, etc)
or the writer of the underlying material (book, play, script, game,
etc) is British. The last point under this section is given if at least
50% of the words in the dialogue are in a British language.
Section B deals with cultural hubs and has a total of 15 points available on the following basis:
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Principal Photography
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1 point
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if more than 10% is carried out in the UK
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2 points
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if more than 25%
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3 points
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if more than 37.5%
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4 points
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if more than 50%
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5 points
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if more than 62.5%
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6 points
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if more than 75%
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Visual Effects ('digital alteration of a film's image' - a list is set out in the DCMS guidelines)
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1 point
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if more than 10% spent in UK
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2 points
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if more than 25%
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3 points
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if more than 50%
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4 points
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if more than 75%
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Special Effects
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1 point
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if more than 75% spent in the UK
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Music recording
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1 point
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if more than 50% spent in the UK
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2 point
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if more than 75%
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Audio Post-production
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1 point
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if more than 75% spent in UK
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Lab Processing
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1 point
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if more than 75% spent in UK
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The
DCMS has discretion not to award points under this Section B if it
feels the relevant element is "insignificant in relation to the total
amount of work" carried out on the film. Percentages relate to money
spent, other than for principal photography, when they refer to days
worked.
Section C covers cultural practitioners and awards a
total of 13 points. Here, the person does not have to be British, but
a citizen or resident of any EU State. The points available are as
follows:
Director - 2 Points
Scriptwriter - 2 Points (1 each for two of the three lead writers)
Producer - 1 Point (at least one producer must qualify)
Composer 1 Point
Actors - 2 Points (1 each for two of the three lead actors)
Cast (excl. extras) - 1 Point (if more than 50% of cast qualify)
Heads of Department (HoD) - 3 Points (3 if more than five, 2 if three or four, 1 if one or two)
Crew - 1 Point (if more than 50% qualify)
There
are slight amendments for the Cultural Tests when applied to animation
and documentaries, and these are set out in the DCMS Guidelines.
The Archive Footage Test
Lastly,
in order to qualify as a British Film, the archive footage test must
also be satisfied. There are no new Guidance Notes on this, so it is
assumed that the rules requiring no more than 10% archive footage
(other than for documentaries) will apply as they always have done.
Note
one point of possible confusion. The old " maker " requirement (that
the film-maker be an EU resident or company) still currently exists in
the new Films Order regulations (mentioned above) and so for now is
still a legal requirement, albeit mistakenly. The intention was that
the maker requirement would no longer necessary if the film passed the
other two tests (ie. the Cultural Test and the Archive Footage Test).
Accordingly, the draft Finance Bill, which won't come into force until
passed through Parliament later in the summer, corrects the position
and will (assuming no amendments) remove the maker requirement
altogether. However, it is a little confusing as to what the position
is in the meantime.
(iii) "...has the requisite amount of core expenditure incurred in the UK..."
Not
less than 25% of the core expenditure of the film, being money spent on
pre-production, principal photography and post-production (see below
for more information), must be spent in the United Kingdom by the FPC
(or in the case of an official co-production, by the co-producers in
aggregate). The figure of 25% has been reduced from the 40% originally
proposed in order to allow more films to qualify probably to bring the
threshold closer to the minimum for most official co-productions.
(iv) "...and commences principal photography on or after 1 April 2006."
Simply,
a film that started principal photography before 1 April will have to
rely on the old section 48 (or section 42) regime, as it will not
qualify for the new relief. However, the old system only covers films
completed by 1 January 2007 or acquired by 1 October 2007, so if the
film does not comply with either of these criteria (as is the case with
the latest Harry Potter, for example), it will fall outside the tax
benefit net altogether. That said, it is probable that the authorities
will entertain individual submissions on a film by film basis should a
production suffer this fate. The Background Notes to the new
legislation confirm this, and at present, additional statutory
regulations are apparently being prepared to legislate for it.
HOW MUCH DO I GET?
New rules for tax treatment, plus an "additional deduction" (a.k.a. "enhancement")
At
the end of each accounting year, the FPC will submit its tax return to
HMRC (the UK's Inland Revenue and the Customs & Excise departments
merged last year to become Her Majesty's Revenue and Customs, or
"HMRC"), declaring a profit or loss. It will pay taxes on its profits,
or alternatively carry forward, backwards or sideways any losses, in
accordance with standard accounting practice. The Finance Bill updates
the rules on computing profits and losses in relation to film income
and expenditure. The general accounting rules for the new tax treatment
of films (the "basic treatment ") are set out in Schedule Four of the
Finance Bill, and are covered later in this Guide, but the bit you
probably want to know about first is the so-called "additional
deduction" (also known as the enhancement ). This is the artificial
amount that an FPC can effectively add to its actual expenditure,
thereby reducing any profit (or creating or increasing a loss),
resulting in a lower overall tax bill. Furthermore, if it makes a loss,
the FPC can "surrender" part of it in return for the payment of a "tax
credit" from HMRC. First, we'll look at how the additional deduction is
calculated, and then we will look at how to "convert" a loss (or part
of it) into the tax credit. Lastly, we will look at Schedule Four.
Wading through the various definitions to determine "qualifying expenditure"
There
is a whole host of new definitions in the draft legislation covering
different types of activities and expenditure which, at first, can seem
quite confusing. The important ones are covered in the Glossary at the
end of this Guide. However, what you need to know in a nutshell, in
order to work out your qualifying expenditure (used to calculate the
additional deduction), are the following. Film-making activities are
those involved with the development, pre-production, principal
photography, post-production of a film. Production expenditure is
expenditure on these film-related activities. Core expenditure is
production expenditure other than that on development. And a
limited-budget film is one whose core expenditure does not exceed £20m
(assuming transactions are on an arm's length basis). Finally,
qualifying expenditure is the amount of core expenditure permissible
under the general basic treatment accounting rules (see below) when
calculating profit and/or loss.
It follows that qualifying
expenditure is, in essence, money spent on pre-production, principal
photography and post-production. Quite what constitutes pre-production
(rather than development ) expenditure is unclear, and HMRC
deliberately evades the questions by stating in its FAQs that the terms
"are well understood in the film industry and take their normal
meanings for the purpose of the legislation". This is particularly
unhelpful with regard to the timing of underlying rights options and
acquisitions ( see below), and to the securing of above-the-line
talent. Using "financial closing" as a trigger date would seem
inappropriate as pre-production is often well underway by that point.
Regarding development expenses, note that section 41 ( Finance Act (No
2) 1992 ), which currently deals with "preliminary expenditure"
(development) will be repealed on ratification of the Finance Bill in
the summer, and is not replaced by any specific provisions. Producers
are therefore strongly advised to take professional accounting advice
on any tax relief they wish to claim on development from then on.
Another
worry is the treatment of underlying rights acquisition (eg. buying the
film rights to a book) and copyright clearances (licences to use songs,
pictures, etc, in the film). Whereas the phrase "rights, goods and
services" is used elsewhere in the legislation, the definition of "core
expenditure" - which is used to calculate the additional deduction
(enhancement) - simply refers to goods and services. There is no
mention of money spent on rights so, despite general practice that
acquisition rights are part of production rather than development,
there is a danger that they will be excluded. Whether the provision of
"services" will be deemed to include rights licences - as they are for
VAT purposes - is unclear, but if not (and this seems to be HMRC's
current view), it will reduce further the amount of the additional
deduction available (see below).
Note also that the draft
legislation doesn't give any further detail on what constitutes film-
related activities generally and that, in particular, it doesn't
mention financing or delivery. It is therefore unclear whether
financing fees, executive producer fees, completion bond premiums or
delivery costs will be included as core, and therefore qualifying,
expenditure. However, the draft legislation does expressly leave the
door open for the Government to make further regulations stating that
certain specified elements may or may not to be included as
film-related activities or (as the case may be) qualifying expenditure.
Until that happens, there will be a certain level of uncertainty as to
how these costs will be dealt with. Whereas producers generally accept
these as standard intrinsic costs of producing their film, the HMRC may
or may not conclude that they are in fact "film-making activities".
In
particular, the existence of a completion bond is, most would argue, an
intrinsic part of the production process. The guarantor often provides
invaluable advice and direction, thereby increasing the quality of the
finished film, and so the bond fee should be included as an expense on
a film-making activity. However, there is a worry that HMRC might
consider the bond to be a tool solely for the benefit of financiers,
and therefore not a "film-making activity", thereby rendering the bond
fee as non-qualifying expenditure. Urgent formal guidance from HMRC on
this point would be very useful, to enable proper financial planning.
Calculating the "additional deduction"
The
additional deduction (enhancement) is calculated by multiplying the
rate of enhancement (being 100% for a limited-budget film, otherwise
80%) by the amount of qualifying expenditure that happens to be UK
expenditure, or 80% of the total qualifying expenditure, whichever is
the lower amount.
In a world where UK producers want to make
international stories, these elements have arguably been the most
contentious part and biggest disappointment of the new tax regime.
In other words, the qualifying expenditure is capped
at 80% even if the UK expenditure element exceeds this. It follows
that, if the film is 100% made in the UK, only 80% of the expenditure
can be used in calculating the enhancement. This cap is in order for
the tax relief to comply with EU State Aid regulations. For these
purposes, UK expenditure is defined as any expenditure on services
performed or goods supplied in (or fairly and reasonably apportioned
to) the United Kingdom. It follows that "British produced" films, to
the extent that they are shot outside the UK, will not qualify for an
enhancement, notwithstanding the fact that they may use 100% British
cast and crew whilst abroad. This will incentivise producers to use
local crew on foreign shoots, especially as they are often less
expensive and, of course, don't incur such heavy travel costs (although
outbound travel costs can be included). It would knock out "British"
productions such as Lawrence of Arabia, The English Patient, The
Constant Gardener, and Hideous Kinky from qualifying under the new
rules, if those films had been made today. Conversely, however,
"foreign produced" films that are shot in Britain and that meet the
other conditions will qualify for the enhancement. Confusion may also
arise as to whether or not in fact the supply of goods or, in
particular, performance of services, indeed occurs in the UK (eg.
equipment rented from the UK but used abroad, or costumes made abroad
but used in the UK).
In a world where UK producers want to make
international stories, these elements have arguably been the most
contentious part and biggest disappointment of the new tax regime.
So,
to take an example Film A , costing £10m (ignoring development and any
other excluded costs) and made wholly in the UK, the additional
deduction would be 100% (the rate of enhancement for a limited-budget
film) of the qualifying expenditure, being the UK expenditure capped at
80% of the total £10m, in other words £8m. For a £30m film, Film B, of
which half was spent in the UK, the additional deduction would be 80%
(the rate of enhancement for larger films) of £15m (the UK qualifying
expenditure), in other words £12m. Note that if Film B was made
entirely in the UK, the qualifying expenditure would be capped at £24m
(80% of the total), and the additional deduction would therefore be
£24m multiplied by 80% (being the relevant rate of enhancement), in
other words £19.2m, or 64% of the budget.
For Film A , we said
that the entire spend was in the UK (and was therefore "qualifying
expenditure"), and so it got the maximum enhancement of £8m. If,
however, only 50% was spent in the UK (thereby below the cap), the
enhancement would be 50% of the budget, ie £5m, and so on. You will
recall that the minimum UK spend to qualify for the special film relief
is 25%, so that is the minimum enhancement available.
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Film A (£10m) |
Film B (£30m) |
Percentage Spend in the UK
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100%
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50%
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100%
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50%
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| Qualifying expenditure (capped at 80% |
£8m
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£5m
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£24m
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£15m
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Rate of Enhancement
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100%
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100%
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80%
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80%
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Additional deduction
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£8m
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£5m
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£19.2m
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£12m
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Surrendering losses in return for a tax credit
Remember
that the additional deduction (enhancement) calculated above represents
the extra expenditure that the FPC is deemed to have spent when
calculating its profits / losses. However, the FPC can choose, instead
of simply enhancing its permissible expenditure, to "surrender" its
actual loss (or part of it) to HMRC in return for a direct cash
payment. This is the famed tax credit .
The amount of the loss
that can be surrendered (the "surrenderable loss") is defined as the
lesser of (i) the available qualifying expenditure (which we'll call "
AQE ", see below), and (ii) the deemed trading loss for the relevant
period. We will assume for present purposes that this is in fact the
former (ie. the AQE), although in reality this might not be the case if
the FPC is deemed to make a smaller trading loss, or even no loss at
all (See "SCHEDULE FOUR AND THE BASIC TREATMENT" below). This is an
important point, as a trading loss of an amount less than the AQE would
significantly reduce the tax credit available. This is particularly
worrying if sales estimates are used in the calculation of deemed
income (see SCHEDULE FOUR below).
In the first year, the
"available" qualifying expenditure (AQE) is equal to the whole
"qualifying expenditure" referred to above (when we looked at the
enhancement). However, if the film production spans more than a year,
it is modified (ie. reduced) to take account of any qualifying
expenditure that has previously already been "enhanced" to create an
additional deduction, and is therefore no longer "available" later for
surrendering in return for a tax credit.
Note that any
surrenderable loss that is not surrendered in any year before
completion can be carried forward and offset against the same film
(trade), and after completion can be used in accordance with the normal
accounting treatment of trade losses, including the use of group relief.
The
amount of the tax credit available is calculated by multiplying that
part of the surrenderable loss that the FPC wishes to surrender against
the payable credit rate, which is 25% for limited-budget films, or 20%
for other films. The receipt of the tax credit is not considered income
in the hands of the FPC, and HMRC reserves the right to withhold it if
the FPC owes HMRC any income tax (PAYE) in relation to its employees,
or if its claim is "under enquiry".
So, assuming for now that
the surrenderable loss equals the AQE, we can calculate the maximum
possible tax credit available for our example films. This would be £2m
for Film A , being 25% of the £8m surrenderable loss, and is equal to
20% of the budget, the headline amount. For Film B (£30m budget with
half spent in the UK), the maximum credit would be £3m (20% of the £15m
surrenderable loss), equal to 10% of its budget. If Film B was made
100% in the UK, the tax credit would be worth £4.8m (being 20% of the
£24m AQE), or 16% of the budget. This assumes that our example films
were produced in a single accounting year, and that no additional
deduction (enhancement) was made previously.
It's a technical
point, but note that the figure arrived at in calculating a possible
"additional deduction" (your "extra" allowable expenditure) is not
necessarily the same figure used in calculating the value of the tax
credit (your "actual" loss for the year capped at 80% of the budget),
despite in practice it often equating to the same amount.
| |
Film A (£10m)
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Film B (£30m)
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| Percentage spend in the UK |
100%
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50%
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100%
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50%
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Available qualifying expenditure / trading loss
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£8m
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£5m
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£24m
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£15m
|
| Tax Credit rate |
25%
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25%
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20%
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20%
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Maximum tax credit...
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£2m
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£1.25m
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£4.8m
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£3m
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... as a percentage of budget
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20%
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12.5%
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16%
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10%
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HOW AND WHEN DO I RECEIVE THE TAX CREDIT?
The
special film relief is normally available in respect of the accounting
period in which the DCMS has, after checking the production accounts
(etc), certified that the "completed" film has qualified under the
British Film conditions. A film is considered completed when it is
first "in a form which can be regarded as ready to be copied and
distributed for presentation to the general public", although the
relief is also available on a film which has been "abandoned". Note
that the definition of "completed" doesn't state "capable" of being
distributed; it means actually "ready...for the general public", so it
should be taken to mean the date of delivery to the sales company
rather than of the first test screenings.
However, for the
first time, it will now be possible to obtain an interim certificate
from the DCMS, possibly coupled with conditions and/or an expiry date.
Quite how useful such interim certificates will be for financing
purposes is not clear, and it will probably depend on how willing the
banks (etc) are to lend against them (see below), particularly as they
are revocable under certain circumstances.
That said, if the
FPC wishes to claim interim tax relief (prior to completion), on the
basis of a statement detailing planned UK expenditure, it will need an
interim certificate.
SO HOW CAN I USE THE TAX CREDIT FOR PRODUCTION FINANCE?
If,
taking our Film A example, the FPC surrenders all of its available
qualifying expenditure (AQE) in return for the tax credit, it could get
£2m (being 25% of the £8m AQE, as the film is under £20m) after
completion and certification of the film. This £2m tax credit might be
a nice gift for the FPC once the film is completed, but the producers
probably would have preferred the money up-front, and to use it as part
of the finance for making the film in the first place.
Discounting the tax credit
To
do this, the FPC would have to persuade someone (a lender of some
sorts) that the film will definitely qualify as British, in order for
that someone to lend the FPC some money against "picking up" the tax
credit cheque on completion. Of course, the tax credit is only payable
to the FPC, but it can contract with the lender to pay it over once
received, as part of - or outside - the recoupment waterfall. It would
not be taxable income in the hands of the lender if paid as part of the
loan repayment. It will probably be between six months and two years
from the date the money is needed for production to the date the tax
credit is paid by HMRC. Any amount lent would therefore be less than
the full £2m (20% of Film A's budget), as the lender would have to
factor in its fees, interest, and the fact that it is potentially a
risky loan as the film may not ultimately qualify for whatever reason.
It's
much more likely that the amounts lent in this way will be closer to
between 15% and 17% of films' budgets (£1.5m to £1.7m for our example
Film A ). Although this doesn't quite give the producer the 20%
headline benefit, it is no coincidence that it is slightly higher than
the amounts traditionally available under the previous sale and
leaseback regime, and this was always the Government's intention. Of
course, it does require some form of financial intermediary to step in
to cash-flow the tax credit, which directly conflicts with the
Government's much published desire to rid the tax incentive regime of
so-called "middlemen".
It might take a year or two before the
traditional banks are willing to dip their toe in the discounting
water, as they will probably first want to see the system working fully
and robustly. In particular, if many claims are put "under enquiry"
(see above), causing delays, it would leave the banks somewhat uneasy.
However, it has been announced that HMRC will be training up specialist
film tax assessors, which should speed the process up and give
producers and their accountants access to officials who actually
understand the world of film financing.
AT WHAT POINT DO I START PAYING TAX ON THE FILM'S "PROFITS"?
The
best way to illustrate this is through some simple numerical examples.
Let's return to our hypothetical £10m Film A from before. It's a
limited-budget film made 100% in the UK, and passes the new Cultural
Test as a British qualifying film. It follows that it will qualify for
the maximum enhancement of 80%, equal to £8m. Remember, the 80% cap is
imposed to comply with EU State Aid regulations.
The initial
position, therefore, is that the FPC is "deemed" to have spent £18m
(£10m to make the film plus the £8m enhancement). Ignoring for now any
"surrender" for the tax credit (we'll look at this later), the FPC can
therefore receive a total of £18m in income, to match its deemed £18m
spend, before making a profit and thereby having to start paying tax.
The
important question is, when will the FPC be deemed to have received
£18m income? To answer this, we need to look at how the film was
financed to see how much of that money (received by the FPC in order to
make the film in the first place) is considered income. Let's say, for
the purposes of our example, that the £10m was fairly typically
financed, and made up of :
£3m in pre-sales,
£3m in equity,
£0.4m
deferments
£2m bank gap
and a £1.6m "final piece" which we'll look at
later.
And, for simplicity's sake, we'll ignore interest, premiums,
commissions, etc, that may be payable during recoupment of the various
elements of finance.
The pre-sales are clearly income , as they
are receipts from the sale of the film or rights in it (see SCHEDULE
FOUR, below). They are "sales" in the same way that any company sells
its goods or services, and therefore the FPC will be considered to have
received income of £3m in this regard. It can therefore only receive a
further £15m before paying tax. This income from presales is deemed to
be received at the time the film is completed and delivered (when the
distributor pays up), rather than at the earlier time of the
discounting by the bank.
The bank gap, on the other hand, is a
loan. It has to be repaid, and is therefore not income in the hands of
the FPC. And despite its name, the " equity " funding is also
technically a loan as it also has to be repaid, albeit on softer terms
than, and ranking behind, the bank. So it too is not considered as
income.
The deferments were never actually received in the way
of cash, so are also not considered to be income. They can almost be
seen as "loans" to the FPC by the relevant producer(s), actor(s),
director, etc.
So far, therefore, the FPC can receive a further
£15m (total available £18m less £3m presales) in income from Film A
before paying tax. Now let's consider the £1.6m "final piece" used to
complete the financing of the film. Naturally, if this is additional
equity or a loan , it will not be considered income, and will have to
be repaid from receipts from exploitation of the film. On this basis,
the FPC would "break-even" once it has repaid £7m towards financiers'
recoupment (£2m to the bank, £3m in equity, £0.4m deferments and the
£1.6m "final piece"). This means that further post break-even revenues
(ie. " profits ") of £8m can be received before any tax liability kicks
in (the £8m being the £18m total permitted income less the £3m presales
and the £7m received and paid out to financiers to reach break-even).
In other words, the FPC can receive a total of £15m in net sales
revenues (excluding the financing presales) before paying tax. It is no
coincidence that the £8m permitted tax-free "profit" is equal to the
enhancement (80% of the £10m budget).
If, on the other hand,
the "final piece" was received in return for some actual rights in the
film (not just a right to receive income), then just like a pre-sale,
it won't have to be repaid, and will be considered income. The total
"income" received in the way of production finance would therefore be
$4.6m (£3m presales plus £1.6m final piece), meaning the FPC can then
receive a further £13.4m (£18m permitted income less the £4.6m already
received) in income before paying tax. Of this, it will have to repay
£5.4m to financiers in recoupment (the bank plus the equity plus the
deferments), leaving it with an additional post break-even income
allowance (ie. tax-free profits ) of, again, £8m (£13.4m less the £5.4m
recoupment).
if an appropriate lender can be found, the discounted tax credit in our
example could, if required, be used as the £1.6m "final piece"
So, however you look at it, after paying off its
financiers, the FPC for Film A can receive "profits" (income after
recoupment) equal to 80% of its budget before paying tax. This is the
additional deduction. But of course that's not the end of the story.
The UK Government has acknowledged that this "final piece" is often
difficult to get hold of, and can be the make or break of producing the
film. Hence the introduction of the "tax credit" element.
Now,
if an appropriate lender can be found, the discounted tax credit in our
example could, if required, be used as the £1.6m "final piece". It
would not, of course, be considered "income" for taxing purposes. If it
surrenders its entire AQE for the tax credit, the tax position of the
FPC would be as follows. Total production expenditure is £10m, with no
"enhancement" (you can't have both your enhancement and the tax
credit!). It can therefore receive an equivalent £10m in total income
before going into profit and paying taxes. Income received from
financing is £3m (presales only - none of the other forms of production
finance were considered "income"). Total finance to be recouped by the
financiers (bank, deferments and equity) is £5.4m. Therefore the amount
of tax-free income receivable once the film has broken even is £1.6m
(ie. £10m expenditure less £3m financing income and less £5.4m
recoupment), which, of course, is equal to the amount of the discounted
tax credit "final piece".
There are a number of accounting
issues which might favour an earlier or later surrender of the AQE for
the tax credit, and professional advice should be sought as to how to
maximise the available incentives and minimise the FPC's ultimate tax
bill(s). One thing is for sure, however, and that is that the sooner
the various uncertainties can be ironed out, the lower the risks for
discounting, and the sooner the banks will enter the market (hopefully
taking lower fees than those likely from private financial middlemen).
"SCHEDULE FOUR" AND THE BASIC TREATMENT
Schedule
Four of the Finance Bill sets out the general tax treatment (other than
that specifically in relation to the enhancement and tax credit) for
films which commence principal photography on or after 1 April 2006. It
basically explains what can be included as costs, how to calculate
income, and therefore how to calculate the profit or loss that the FPC
makes (ignoring the enhancement and tax credit), whether or not the
film qualifies as British. Without these provisions, the cost of a film
would have to be dealt with as a capital investment, rather than
expenses that can be written off against income. It is essential to
take professional accounting advice on these matters, but below is a
very brief summary of the provisions.
Film production as a trade; expenditure, income and profit
Each
film produced by an FPC is considered a separate trade. The trade
commences at the beginning of pre-production (unless income is received
earlier), and any previous development expenditure is deemed to have
been spent on the first day of pre-production. The old "section 48"
(and section 42) system treated expenditure on the production or
acquisition of a master version of a film as revenue, rather than
capital, in nature, and the theme of income-matching rather than
capital expenditure has been continued, but only for production (not
acquisition).
Under the new regime, the costs in any given
accounting period that comprise permissible expenditure on a revenue
basis are those incurred on film-making activities (see above) together
with activities " with a view to exploiting the film ". Normal
exclusions apply, such as entertainment costs and interest.
Income
comprises any receipts in connection with the making or exploitation of
the film and specifically includes (i) receipts from the sale of the
film or rights in it, (ii) royalties, (iii) payments for ancillary
rights (games, merchandising, etc), and (iv) receipts of film profits.
In determining profit (or loss) for each accounting period, you deduct
the costs incurred in the relevant period from an apportioned "deemed"
income. Although to the "lay" person, receipts in connection with the
making of the film might sound like it applies to all moneys used to
finance the production (including loans, equity, etc), standard
accounting practices (in particular SAP 9) will be followed on a
"prudent basis", and receipts will be accounted for if they are not
repayable, thereby excluding equity, loans, and so on. Therefore, it is
expected that only revenues actually contracted for will be included as
receipts for the purposes of calculating income.
This deemed
income is measured by calculating the percentage of total anticipated
costs that has actually been spent in the relevant period, and
multiplying it by the total amount of income reasonably and fairly
expected from the film, considering all the relevant circumstances. For
example, if at the end of the relevant period, 74% of all production
costs have been spent, the company will be "deemed" to have received in
the same period 74% of its total expected income.
The issue
here is how one decides what the total expected income is going to be.
It was feared that HMRC would insist on using the Sales Estimates
(projections) normally obtained by the producer prior to production in
estimating total income, rather than actual contracted income. Had that
turned out to be the case, it would have had a huge impact on which
sales companies, and what level of estimates, would be used when
preparing finance plans, financial marketing documents, and so on.
However, for similar reasons as stated above (regarding SAP 9, etc) it
loots as though HMRC will not take that approach, as it would mean that
a proportion of the sales estimates will be deemed to have been
received before they actually are (if indeed they ever are). The
knock-on effect would be that the FPC may be deemed to make a
negligible or zero loss in the relevant period, or worse still, a
taxable profit. The FPC's " surrenderable loss " (used to calculate the
tax credit, see above), which is the lesser of the AQE and this trading
loss, would therefore be greatly reduced, or even equate to zero,
thereby considerably reducing the amount of available tax credit.
Costs
are accounted for when the relevant activities are "represented" in the
film (whether or not it's in a completed form), even if they haven't
yet been paid. However, such deferred payments can only be included
where they are (i) unconditional, and (ii) if paid from receipts of the
film, a corresponding amount of income is simultaneously brought into
account. No costs can be included if payment of them is still
outstanding four months after the end of the relevant accounting
period. Any expenditure where other relief has already been given (eg
"preliminary expenditure" under Section 41 of the Finance Act (No.2)
1992 ) is, of course, excluded.
Finally, there are specific
regulations outlawing artificially inflated claims, or arrangements
specifically aimed at getting a tax credit that would otherwise not be
available.
GLOSSARY OF VARIOUS TERMS DEFINED IN THE NEW LEGISLATION
additional
deduction the amount of UK Expenditure (or, if less, 80% of the total
qualifying expenditure) multiplied by the rate of enhancement.
available qualifying expenditure any qualifying expenditure not surrendered in previous accounting periods.
British Film a film certified as such under (modified) Schedule 1 of the Films Act 1985
core expenditure expenditure on pre-production, principal photography and post-production (ie. not development).
enhancement (not to be confused with rate of enhancement) the same meaning as additional deduction
film
making activities the activities on which tax relief is available,
being development, pre-production, principal photography and
post-production.
film production company the company entitled to benefit from the special film relief.
final accounting period the accounting period in which the film is completed (or abandoned).
final certificate the certificate granted after completion of the film, certifying that it qualifies as a British Film.
Finance
Bill the Finance Bill (No.2) 2006, published on 7 April 2006, which
goes before the UK Parliament in the summer of 2006, and if passed
(thereby becoming the Finance Act 2006), will legislate for the rules
brought in by the budget delivered by the Chancellor of the Exchequer's
in March 2006.
FPC a film production company .
interim accounting period any accounting period earlier than the final accounting period.
interim certificate a certificate issued by the DCMS certifying that
the film will certify as British if completed as planned.
limited budget film a film whose core expenditure does not exceed £20m.
payable credit rate 25% for a limited budget film, 20% for all other qualifying films.
producer (for the purposes of the Cultural Test), the person who makes the arrangements necessary for making the film.
qualifying co-producer the person who is the UK co-producer on a qualifying co-production .
qualifying
co-production a co-production made under a UK Co-production Treaty or
the European Convention on Cinematic Co-production.
qualifying expenditure the core expenditure taken into account under Schedule Four .
rate
of enhancement the proportion of UK expenditure that makes up the
additional deduction , currently being 100% for limited-budget films,
and 80% for other (larger budget) films.
Schedule 4 Schedule Four of the Finance Bill , which sets out which expenditure is captured by the new regulations.
special film relief the additional deduction and the tax credit regime.
surrenderable
loss the lesser of the available qualifying expenditure and the actual
trading loss (after taking into account any additional deduction ) for
the relevant accounting period.
tax credit the amount the HMRC pays
to the FPC , being the amount of the surrenderable loss that the FPC
chooses to surrender multiplied by the payable credit rate.
theatrical release exhibition to the paying public in the commercial cinema.
UK expenditure expenditure on goods supplied or services performed in the UK.
Author Adam P Davies is currently Head of Business Affairs at film
financing company VisionInc Ltd, and a co-author of the 330-page Netribution book - the 2005/06 UK Film
Finance Handbook - How To Fund Your Film. To support Netribution and ensure we can keep publishing free
in-depth guides such as this one, please consider buying this
'essential' book (which also contains chapters from James MacGregor and
Nic Wistreich and contributions from Stephen Applebaum).
"As a reference book it's excellent - as a friendly, informative and
conspiratorial companion to your filmmaking it's essential"
Close Up Film
"The last version was good but this is in a league of its own - it is very well written and structured" Katharine Robinson, producer Cheeky Monkey Films (including 2004 Nokia Shorts winner)
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Thanks again Adam. Respect.