The new Tax Relief System for British Films

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.

This Guide is not intended as an exhaustive or thorough legal description of the new legislation, and any person looking to benefit from the tax incentives available is strongly advised to take legal, tax and accounting advice from his or her professional advisers.

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).

{mospagebreak}

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:

Principal Photography	1 point	if more than 10% is carried out in the UK
	2 points	if more than 25%
	3 points	if more than 37.5%
	4 points	if more than 50%
	5 points	if more than 62.5%
	6 points	if more than 75%
Visual Effects ('digital alteration of a film's image' - a list is set out in the DCMS guidelines)	1 point	if more than 10% spent in UK
	2 points	if more than 25%
	3 points	if more than 50%
	4 points	if more than 75%
Special Effects	1 point	if more than 75% spent in the UK
Music recording	1 point	if more than 50% spent in the UK
	2 point	if more than 75%
Audio Post-production	1 point	if more than 75% spent in UK
Lab Processing	1 point	if more than 75% spent in UK

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.

{mospagebreak}

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.

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.

{mospagebreak}

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).

{mospagebreak}

"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.

This Guide is not intended as an exhaustive or thorough legal description of the new legislation, and any person looking to benefit from the tax incentives available is strongly advised to take legal, tax and accounting advice from his or her professional advisers.

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)