Sale and Leaseback of British Films

The Materials These materials specifically cover the following areas:

These materials have been provided by the • Qualification Checklist Media and Creative Industries Group of • Brief History of Sale and Leaseback Transactions Dorsey & Whitney and are intended for use • The Parties as general reference material on the topic of • The Basic Transaction British film sale and leaseback transactions. • The Documentation • The Purchase Price Dorsey & Whitney is an international law • Benefits firm with 21 offices across the United States, • End of the Lease Term Europe and Asia. As a team of seasoned • Definition of a “British Film” lawyers who are intimately familiar with the • Co-Production dynamics of the creative industries, Dorsey & • Recent Developments Whitney’s Media and Creative Industries Qualification Checklist Group provides tailor-made solutions The following is a qualification checklist, which designed to meet the needs of media and producers should consult when considering whether a entertainment clients operating at national particular film will qualify for a sale and leaseback and international levels. transaction. 1.1 Is the production company registered and The Group regularly calls upon the expertise centrally managed/controlled in the UK, or in of colleagues across many time zones, a state that is a member of the EEA1 or is a specialising in areas as diverse as intellectual signatory of the EC Association Agreement2 property, acquisitions and sales, licensing, (“Eligible State”)? financing and tax planning. This depth of 1.2 Is 70% of the production cost of the film being capability enables the Group to provide a spent on filmmaking activity in the UK? (If the seamless service to clients involved in the costs of one or two people are deducted from film, TV, video, DVD, music, fashion, the total labour costs - as detailed in 1.3 and 1.4 below - then the same costs must be deducted advertising, publishing, sport and leisure, from the total production cost before the 70% computer games and technology sectors. test is applied). 1.3 Can any key actor and/or production crewmember be considered Non-Qualifying Labour (i.e. not a citizen or ordinarily resident in an Eligible State or a Commonwealth

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Country3 (hereinafter “Qualifying Labour”))? The Parties If so, then you may deduct the labour costs for A typical Sale and Leaseback transaction involves a one such non-qualifying person, then calculate Seller (usually a film production company) and a Buyer to ensure that 70% of the total labour cost is (usually a “film trading partnership”). being paid to Qualifying Labour. The Seller: must be registered and centrally managed 1.4. Alternatively, you may deduct the labour costs and controlled in the UK or another Eligible State. of two such non-qualifying individuals (one of whom must be an actor engaged in no other The Buyer: it’s important to note that film finance tax capacity), then calculate to ensure that 75% of relief (based on acquisition) is only available to entities the total labour cost is being paid to Qualifying or persons who acquire films in the course of their 4 Labour. business or trade. Thus, individuals who simply want to 1.5 Is no more than 10% of the playing time of the make a one-off investment in a film may not take film comprised of a sequence or sequences of advantage of this particular tax break. visual images from a previously certified film or In order to benefit, investors normally band together from a film by a different maker?5 into “film trading partnerships” (resident in the UK for 1.6 If one or more of the above requirements tax purposes) cannot be met, was the film made as an official that actively co-production pursuant to a co-production engage in the treaty?6 “Individuals who simply “business” of Brief History of Sale and Leaseback want to make a one-off acquiring and leasing films. Transactions investment in a film may not take advantage of this These partner- Thanks to industry lobbying efforts, British films have ships are usually benefited from various forms of tax relief for several particular tax break.” comprised of years. This tax relief functions to (1) provide tax high-net-worth incentives which benefit the makers of British films and individuals with (2) stimulate a large amount of outside investment in sufficient taxable income to absorb or take advantage of British films, thus providing British filmmakers with an the tax relief. excellent source of financial capital. The Basic Transaction While early forms of film-related tax relief came into The Buyer purchases the master negatives/tapes of a existence around 1979, in 1992 the Inland Revenue completed,9 qualifying British film (along with began to affirmatively grant producers and acquirers of worldwide distribution rights) from the Seller, and then British films tax relief equal to 33.3% of the film’s total immediately leases the negative/tape and all production costs. In 1997, this relief was extended to distribution rights back to the Seller (usually for a an amount equal to 100% of the production costs (for period of 10-15 years). films costing £15 million or less),7 during the year of expenditure.8 Initially slated to last until 1 July 2003, in Pursuant to the lease, the Lessee (Seller) is required to his budget speech of 2001, Gordon Brown announced make escalating annual rental payments to the Lessor that this relief would now continue for at least another (Buyer) over the term of the lease. These rental two years, until 1 July 2005. payments typically escalate at around a rate of 5% per annum. Historically, the definition of “British Film” for the purposes of tax relief has been liberally interpreted so as In almost all cases, the rental payments must be secured to include television programmes. However, Section by way of a bank guarantee or a standby letter of credit. 99 of the Finance Act 2002 restricts tax relief to The bank that provides such a guarantee or letter of expenditure on films “genuinely intended for theatrical credit will also normally require the Lessee to place a release.” The Government’s clear intention is to prevent significant proportion of the purchase price in escrow television programmes (soap operas in particular) from with a deposit bank. Over the period of the lease, this being able to claim relief. amount in escrow (plus any interest accumulated) will serve to meet the Lessee’s actual liability and the bank’s potential liability with respect to the rental payments.

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In addition, in almost all cases the Buyer will have This analogy is not perfect, however, since a significant borrowed around 90% of the money used to purchase proportion of the purchase price is being held in the film. The Buyer will therefore assign to the lending escrow in order to secure the rental payments. Thus, bank the benefit of receiving all rental payments with the real net benefit of the transaction for the Seller will respect to the film, thus repaying the loan. For this be whatever is left over after depositing this amount in reason, the amount of each annual rental payment is escrow (usually between 10% - 15% of the total typically equal to the amount of each annual loan purchase price, subject to negotiation), minus costs.10 repayment. This leftover sum can be re-invested into the production company, used to pay off debts, buy The Documentation equipment, or for some other purpose. And remember, (1) The Sale and Purchase Agreement the Seller is still benefiting from the commercial (2) The Rights (Intellectual exploitation of the film (subject to Property) Agreement(s) whatever arrangements that exist with distributors, etc.) (3) The Lease Agreement (4) The Laboratory Agreement “It is in both the Seller’s 2. The Buyer: The Buyer benefits (5) The Bank Guarantee by being able to defer (not avoid) tax and the Buyer’s best liability, because it can deduct an (6) The Release of Charges (if interest to obtain the necessary) amount equal to the whole of the highest possible purchase purchase price from its taxable The Purchase Price price for the film.” income for the relevant accounting It is in both the Seller’s and the period. In some situations, the Buyer Buyer’s best interest to obtain the can also benefit from an immediate highest possible purchase price for injection of cash in the form of a tax the film (up to the £15 million cap). refund. However, the Inland Revenue will scrutinise the deal and will only grant relief if the purchase price is an For example, assume a film partnership had a trading accurate reflection of the film’s “value.” Since it is profit (for tax purposes) of £1 million and the partners difficult to gauge a film’s value prior to commercial paid income tax on that amount of say £400,000. If in release, the Inland Revenue’s March 1998 Statement of the next tax year, the partnership had no income and Practice states that an acceptable measure of a film’s incurred £1 million in acquiring the master version of value is its total production expenditure (excluding a film (which it then immediately leased back), the financing costs, advertising, and distribution expenses) partners could obtain relief for the £1 million loss and that Inland Revenue will not challenge such a which could include set-off against the previous year’s valuation where (1) the sale occurs prior to first release taxable income or capital gains and obtain a refund of or broadcast anywhere in the world, or (2) a pre-release any tax previously paid. If, as is sometimes the case, agreement is entered into prior to first release or around 90% of the funds used to acquire the film was broadcast anywhere in the world and the sale occurs financed by bank borrowing (i.e. £900,000), the within three months of this agreement. The Inland partners have essentially spent £100,000 of their own Revenue’s “promise” not to challenge remains valid money in order to receive a cheque of £400,000, even in situations where a proper evaluation of the resulting in an immediate cash benefit of £300,000. film’s future commercial prospects would have resulted However, since this is only a tax-deferral scheme, the in a lower valuation. partners will pay tax on the rentals over the term of the lease, so every year part of the original deferred tax The Benefits liability (£400,000 in this example) is being clawed 11 1. The Seller: The Seller benefits by receiving the back by the Inland Revenue. purchase price, whilst being able to, at the same time, exploit the film commercially (because, remember, they End of the Lease Term have a lease entitling them to do so). Thus, it is At the end of the lease term, the Seller usually regains analogous to selling your house and receiving the possession of the film via an “Agency for Sale” purchase price, whilst at the same time retaining full transaction. This transaction is provided for in the possession of the house and living in it just the same as original leasing agreement and is characterised as before the sale. follows: upon expiry of the lease, the Seller is appointed as the Buyer’s sole and exclusive agent for the purpose

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of disposing of the film. The Seller, in its capacity as calculating labour costs spent on Non-Qualifying and agent, then sells the film for a nominal sum to one of Qualifying Labour (see more below). its own associated companies, thus regaining ownership of it. (3) Labour costs:

The return of the film to the Seller must occur in this (i) the production company may deduct the amount fashion for an important reason: If the Buyer were paid to one (1) person who is Non-Qualifying Labour, simply to agree to give the film back after the expiry of but then must ensure that 70% of the remaining total the lease, then the Inland Revenue could say that the labour costs are paid to Qualifying Labour; or Buyer never actually acquired the film (because their possession of it was strictly limited to the lease term, (ii) the production company may deduct the amounts with no solid rights of ownership) and thus never paid to two (2) people who are Non-Qualifying satisfied the conditions necessary to receive the tax Labour (one of whom must be an actor engaged solely relief. in his/her capacity as an actor), but then must ensure that 75% of the remaining total labour costs are paid to Definition of a “British Film” (See head Qualifying Labour. note 1, “Qualification Checklist”) (4) Borrowed material: No more than 10% of the As touched upon previously, the definition of a playing time of the film may be comprised of a qualifying “British Film” is related to four main aspects sequence or sequences of visual images taken from a of the film: (1) the location of the film production previously certified film or from a film by a different company, (2) the percentage of the production cost maker. However, the Department of Culture, Media spent in the UK, (3) the percentage of labour costs and Sport (“DCMS”) has discretion to allow the use of spent paying Qualifying Labour versus that spent an excess of 10% borrowed material if the film is a paying Non-Qualifying Labour, and (4) the amount of documentary, or if the subject matter of the film so material borrowed from a previously certified film or warrants. from a film by another maker. Co-Production (1) Location of the Film Production Company: Even if a film does not qualify as a “British Film” The film production company must be incorporated in pursuant to the above requirements, it may still qualify an Eligible State and it must also be centrally managed if it was made as an official co-production. The UK is and controlled in that place. Central management and party to bi-lateral co-production treaties with France, control will be deemed to occur in the place where the Germany, Italy, Norway, New Zealand, Australia and company’s executive decisions are made (the nationality Canada. The requirements that must be met for a film and residence of the company’s directors is one of the to be considered an official co-production are set out in factors that would be considered). If the company’s each co-production treaty. Generally, each treaty shareholders exercise an inordinate amount of control requires that two or more co-producers from each over the company, their nationality and residence may country produce the film, and that each co-producer also be relevant. meets minimum levels of creative and financial input. (2) Production costs spent in the UK: At least 70% There are also provisions regarding the acceptable level of the production cost of the film must be spent in the of creative and financial input that may be received from non-treaty parties. UK.12 For purposes of this target, production cost does not include: The UK is also a party to the European Convention on Cinematographic Co-Production, which relates to (i) acquisition or licensing costs of copyrighted works multi-lateral co-productions between the signatories. other than those created for use in the film; This convention applies to co-productions between at (ii) expenditures (including interest) related to the least 3 co-producers from at least 3 separate convention raising or servicing of financing for the film; parties, or co-productions between at least 3 such co- producers and 1 co-producer from a non-convention (iii) business overhead not directly attributable to the party. specific film;

(iv) amounts deducted by the company when

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Recent Developments 3 Antigua & Barbuda Mozambique Australia Namibia There are two recent developments of some Bahamas Nauru importance with respect to Sale and Leaseback Bangladesh New Zealand transactions. Barbados Nigeria Belize Pakistan Papua New Guinea (1) Exclusion of Television Programmes: Botswana Brunei Darussalam St Kitts & Nevis Cameroon St Lucia For several years, the liberal definition of what Canada St Vincent & the Grenadines constitutes a “British Film” allowed producers and Cyprus Samoa financiers of television programmes to benefit from Dominica Seychelles Sale and Leaseback transactions. However, in the recent Fiji Islands Sierra Leone The Gambia Singapore Finance Act 2002, Section 99 restricts film-related tax Ghana Solomon Islands relief to films “genuinely intended for theatrical Grenada South Africa release.” This change applies to all productions Guyana Sri Lanka completed on or after 17 April 2002, or completed India Swaziland Tanzania before 1 January 2002 but not certified before 17 April Jamaica Kenya Tonga 2002 (unless the application for certification was Kiribati Tr inidad & Tobago received before 17 April 2002). Lesotho Tuvalu Malawi Uganda (2) Exclusion of deferred payments from the Malaysia Vanuatu calculation of Production Expenditure Maldives Zambia Malta Zimbabwe Mauritius Section 100 of the Finance Act 2002 narrows the 4 The total labour costs of a film exclude payments that are in definition of “total production expenditure” to exclude respect of living expenses that a person incurs because it is not payments which have not been made by the time of the practicable for him to reside at his usual place of residence while film’s completion, and are not unconditionally payable directly engaged in the making of the film, and are reasonable in within four months of that date. This change applies to the opinion of the Secretary of State. 5 In the case of a documentary, this limit may be extended if an all productions completed on or after 17 April 2002. acceptable case is made to the Secretary of State. 6 The UK is currently party to co-production treaties with France, Some filmmakers (especially makers of low-budget Germany, Italy, Norway, Australia, Canada and New Zealand. films) follow a practice of deferring payments so as to The UK is also a party to the European Convention on distribute them at a later date, out of the film’s Cinematographic Co-Production. 7 Section 48 Finance (No. 2) Act 1997. commercial revenues. Certain of these makers have 8 Section 42 Finance (No. 2) Act 1992 allows for a tax write-off also figured out that they can inflate the projected size over a three-year period for producers or acquirers of qualifying of such payments, include them in their production British films of any size budget. expenditure figures even though they haven’t actually 9 The film is in a form which could reasonably be regarded as made the expenditure, and thereby secure a higher being ready for copies of it to be made and distributed for presentation to the general public (or, in other words, when it’s purchase price when completing a Sale and Leaseback ready to be delivered to a distributor, even if it is later sent back transaction. The purpose of Section 100 is to close this to the producer for changes). In addition, this condition is met particular loophole. even if the film is not intended for general release, so long as it is in sufficient condition for general release. 10 There are costs related to: setting up the bank guarantee (roughly 0.5% of the purchase price), auditing, obtaining the DCMS Certificate, and legal costs. 11 According to “Tax Efficient Review” for every £100 deferred or refunded, the Inland Revenue will claw back over the next 15 years around £82.50. 12 This means production costs related to activity that actually takes place in the UK, not the cost of goods and/or services that Notes are merely provided from the UK or from a UK company. 1 Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, The Netherlands, Portugal, Spain, Sweden, the United Kingdom, Iceland, Liechtenstein, and Norway. 2 Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, and Slovakia.

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