As good as it gets?

Since the government introduced 100% tax relief for British films in July 1997, the UK film industry has enjoyed a glorious period of flirtation with the financial/tax planning sector. The relief is due to expire in July 2005 and battle lines are now being drawn behind the scenes for its extension/replacement/abolition (depending upon your position in the industry or at the Treasury).

As we are only 21 months from the end of the relief, the chancellor’s autumn statement ought to provide a clue to his future intentions.

As most film projects can take years to bring to fruition, and can involve quite fragile funding structures, silence from chancellor Gordon Brown next month would severely damage the short and medium-term prospects of the UK film industry.

Have the reliefs worked to date? In many ways, yes. Despite some perceived abuses, the relief has helped British producers to fund filmmaking here and has led to an increase in the US studios’ involvement in the UK, in the face of stiff competition from many other countries offering their own fiscal incentives.

The Treasury is known to be unhappy with the 100% relief, due to its cost – far in excess of initial estimates – and to some abuses in the late 1990s. Both points have been addressed by changes in legislation.

Why then, would the government want to abolish or tamper with the relief?

The most popular form of exploitation of the relief to date has been through sale and leaseback (S&L). This is traditionally a method of raising cash from capital assets by selling them to another party, then immediately leasing them back across a long period. Although legal ownership is transferred, physical possession is maintained by the original owner.

It is a particularly useful mechanism where (as in film) the asset attracts a 100% tax relief. The effect is to give tax relief on day one of a loan by the investor to the producer.

Thus a lower rate of return than usual is required by the investor.

Typically, the investor will let a film producer pocket some 15% of the sale proceeds of a S&L, and ensure that they deposit the remaining 85% to meet the cost of the total lease payments, usually over 15 years.

When the government decided to introduce the tax relief, it was with a view to helping the UK film industry.

In the early days of S&L, the industry was getting perhaps 33% of the benefit and the financial sector (banks, lawyers, accountants and IFAs) 67%. Although that figure has shifted to about 75:25 in favour of the filmmakers, the transaction costs of the relief are still perceived by some to be too high.

Furthermore, although films are a capital asset and thus capable of S&L, they are not really like, say, a piece of heavy plant.

With a conventional asset S&L, one can commercially justify the rental through the annual usage of the asset.

When producers lease back a film, their commercial justification is not that they will derive annual usage through an income stream over the next 15 years.

Of course, any film is capable of generating income across a 15-year period – copyright lasts a minimum of 50 years – but conventional wisdom has it that only one film in 10 will make money, two to three will break even and six or seven will lose money.

Producers know that their only certainty of income is through initial sales advances, which are normally discounted to provide production cashflow to make the film.

They would hardly pin their hopes on any further income to cover the lease payments. Therefore the producer’s sole commercial justification for entering an S&L is being paid 15% on day one to surrender a tax benefit.

Yet common sense suggests that the tax advantage could be improved by increasing the length of the lease. Although custom and practice have developed a lease of 15 years, why not 20 or 30 years?

This could, however, stretch the Revenue’s sense of credibility too far.

Finally, as S&L – the commonest form of investment until mid 2002 – involves no commercial risk to the financier (as the deposit secures the future rental stream), it promotes the making of any films, not necessarily good films.

Today, quality is an issue.

The financial sector has developed new ‘equity-based’ schemes that provide up to 35% of a film’s budget compared with the 15% available under sale and leaseback. This is more attractive to the producer, but puts the investor at greater risk, and thus the quality of films purchased is a key commercial factor.

These schemes have been developed as a response to market pressures. In 2002, partly to address the question of cost to the Treasury, the government excluded television programmes from the tax relief.

At a stroke this reduced the size of the marketplace by about two thirds and left too many investors chasing too few films.

There is every good reason why government should continue to support the UK film industry, either through the continuation of the 100% relief or through a simpler alternative. British filmmaking is good for the UK economy.

Think of the tax take on the making of a £10m film, the income tax paid by the cast and crew, and the corporation tax paid by the providers of film stock, cameras and lighting.

The apparent ‘cost’ of the 100% tax relief isn’t so great when weighed up against the income to the Treasury generated during the production.

As long as the government can provide some medium-term stability and certainty to film tax incentives, then the industry itself can concentrate on the commercial problems it faces in better integrating the production and distribution sides of the business and turn out successful films on a more consistent basis. Only then can the reliefs claim to be truly effective.

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