10 Alternative Financing

 

If we don't succeed, we run the risk of failure.

Dan Quayle

 

 

Enterprise Investment Schemes (EIS)

Overview

EIS schemes encourage small, higher risk, unquoted trading companies to raise finance by issuing full risk ordinary shares to investors who are resident and ordinarily resident for tax purposes in the UK. They can provide a much needed and valuable source of equity to UK film production companies.

Finance is sourced by the issue of a prospectus to the public and the sale of new, ordinary shares to investors in a ‘qualifying’ public limited company. The production of feature films is classed as a ‘qualifying’ trade.

Investors

1. The investor must hold shares in the EIS investment scheme for at least 3 years.
2. EIS schemes provide a convenient means of tax relief. Individuals previously unconnected with the company in which they invest may:
   1. obtain income tax relief (currently at 20 per cent) in any one tax year on the maximum investment of (currently) £200,000 in any one tax year;
   2. defer capital gains tax in conjunction with the income tax relief at 1(a) above in respect of any chargeable gain arising from the disposal of assets after 28 November 1994 on reinvestment to the value of the amount of the gain in the shares of a qualifying EIS company;
   3. obtain exemption from capital gains tax on disposal of the shares in the EIS investment if the shares are disposed at least 3 years after their issue; and
   4. set any losses on an EIS investment against income or gains at the taxpayer's highest rate of tax.

Film production companies

3. EIS investment offers film production companies an alternative method of raising finance for the development and production of feature films to the more established:

1. film partnerships providing equity investment in the production costs of a film (these schemes afford high net worth investors a 40 per cent tax break on the cost of production but normally have a very high threshold for minimum investment in the scheme);
2. sale and leaseback funds (which may be prevented from being combined with the equity investment under paragraph 3(a) above as so-called ‘double-dipping’); or equity investment in the budget of the film or the film production company by so-called ‘angel investors' (a high risk investment with no guarantee of any return or profits if the film fails at the box office).

4. EIS investment can be in an individual film or slate of films or in the film production company itself.

5. It is also possible to set up:

1. a so-called ‘seed funding’ company that sources EIS investment in order to develop a film or a slate of films to the production stage (for example by purchasing options, preparing budgets, paying scriptwriters, casting and sourcing distribution agreements and pre-sales); and
2. a production funding company which uses EIS sourced funds to purchase the fully developed film or films from the ‘seed funding’ company and funds the production costs of the film.

6. EIS investments funds may be safely combined with sale and leaseback funds.

7. EIS investment does not require negotiations between the investor, the production company and any other investor (such as a distributor or provider of government subsidy) in respect of recoupment corridors and distribution of profits.

Additional benefits to investors

A further incentive to participation in an EIS scheme is involvement in the production of the feature film or slate of films. Investors may be entitled to:

1. visit the set during principal photography;
2. meet the cast and crew;
3. attend the premiere of the film or films; and/or
4. a screen credit.

Pitfalls

The following points are of note:

1. any dividends are taxable;
2. during the minimum investment period of 3 years investors may not hold any rights that protect them from the risk of investment such as the right to redeem the shares;
3. investors may lose their entire investment (although the losses may be set against income or gains at the taxpayer's highest rate of tax under paragraph 2(d) above);
4. the ‘qualifying’ company must be public, thereby exposing it to regulatory and statutory obligations;
5. if the minimum amount is not raised within 40 days of the issue of the prospectus, all funds must be returned to investors; and
6. the benefits of an EIS scheme are geographically limited to people who are resident and ordinarily resident in the UK for tax purposes.

Please also note that this is only a summary and potential investors must obtain independent specialist investment advice before investing in an EIS scheme.

Limited Liability Partnerships

Since April 2001 it has been possible to structure film production and sale and lease back partnerships as a Limited Liability Partnership (‘LLP’). Although LLPs were originally conceived to be used for professional partnerships, such as architects and accountants, they have become the vehicle of choice for anyone seeking to set up a film fund.

An LLP is a hybrid between a limited company and a partnership combining the limited liability of a company with the flexibility and tax transparency of a partnership and can therefore be a highly attractive vehicle for film investors.

To understand why LLPs have superseded the previously more common Limited Partnerships (LPs) as the preferred fund vehicle, we will look more closely at the LLP structure, highlighting, where relevant, their advantages over LPs.

Limited liability

An LP generally offers limited liability for investors. However, one partner must still act as a general partner (GP) with unlimited liability. In practice, a special purpose vehicle without assets is usually set up as the GP to try to ‘ring fence’ any potential liability. In an LLP all the partners (or ‘members' as they are more commonly known) enjoy limited liability and their position is largely analogous with that of shareholders in a limited company in that, subject to certain limited exceptions, the liability of any member of an LLP is limited to his or her capital contributions made to the LLP. An LLP also exists as a separate ‘body corporate’ with its own distinct legal personality separate from that of its members and, unlike an LP, will contract in its own name.

Tax transparency

Both LPs and LLPs are tax transparent vehicles, that is to say that each of the investing members is considered to be undertaking a pro-rated part of the partnership trade with a view to a profit (this last requirement excludes charities from being set up as LLPs or other forms of partnership). However, this may cause some timing difficulties in terms of a member's individual tax liability in that, if a profit accrues to the LLP, the member will be liable to pay tax on such profit when it accrues without necessarily receiving the requisite distribution from the partnership itself.

Designated members

Unlike an LP, an LLP is required to have a minimum of two ‘designated members' who are responsible for undertaking certain statutory functions on behalf of the partnership as required bythe Limited Liability Partnerships Act 2000 (the ‘LLP Act’). These include notifying the Registrar of Companies of certain changes to the Partnership and ensuring that an annual return and accounts are filed with the Registrar of Companies. Unless certain members are notified to the Registrar as being the designated members of the LLP then each and every member of the partnership will be treated as a designated member.

Confidentiality

Like a limited partnership, the main document that governs the relationship of the members in an LLP, i.e., the Members' Agreement (see below), is confidential and need not be filed with the Companies Registrar. However, unlike limited partnerships, LLPs are required to have their accounts audited and, once filed with the Registrar, these accounts will be publicly available from Companies House.

Insolvency

Members of LLPs are subject to a statutory ‘clawback’ provision that provides that any amount withdrawn by members in the two years before the commencement of a winding-up of the LLP may be required to be repaid to the LLP or ‘clawed back’ if the person making the withdrawal knew or could have reasonably concluded that after the withdrawal there was no reasonable prospect that the LLP would avoid an insolvent liquidation.

Incorporation of the LLP

Much like limited companies, LLPs are incorporated by registration at Companies House and the incorporation document (Form LLP2) must be submitted by the initial members of the LLP. The Form LLP2 will set out the name of the LLP, the registered office address, details of the initial members and will identify which of those members are to be the designated members, together with a statement that the LLP complies with the LLP Act.

On incorporation, the Registrar of Companies will issue the LLP with a Certificate of Incorporation, stating the registered number of the LLP together with its date of incorporation, and the Registrar will also issue to each of the designated members a unique designated member number.

The name of the LLP, as is the case for limited companies and business names, will only be registered if it does not contravene one of the many restrictions in relation to the use of certain words. In addition, it will not be possible to register an LLP with the same name as that of an existing limited company.

Members' agreement

An LLP does not have a Memorandum or Articles of Association as a limited company would have, nor does it have a specified management structure. Therefore, it is up to the members to agree amongst themselves how they should run and regulate the LLP. It is important that a properly drafted Members' Agreement is prepared to set out the terms of the partnership, especially as partnership law cannot be expressly implied in relation to those terms.

The Members' Agreement should cover, amongst other matters, the following:

• the capital contributions made by members and how these may be increased or transferred;
• the profit sharing ratio;
• how decisions of the LLP are made;
• the procedure for admitting new members;
• the identity of the designated members and the scope of their designated authority, if any, over and above their statutory duties;
• the intended lifetime of the LLP and how it can be wound-up;
• how the Members' Agreement can be amended and the procedures for meetings of members.

Financial Services Regime

Many LLPs, utilized as film fund vehicles will, unless the members have had the responsibility for the ‘day to day’ running of the LLP (which recent case law states must be actual involvement as opposed to the right to be consulted over the more material matters of the business of the LLP), constitute an unregulated ‘collective investment scheme’ (CIS) for purposes of the Financial Services and Markets Acts 2000 (FSMA) and the Financial Services Authority (FSA).

The implications of an LLP being a CIS are that the LLP will be required to appoint an FSA-authorized ‘operator’ to the scheme to undertake the regulated activities of the scheme, such as admitting new members to the Partnership. Whilst the sponsor ofany film partnership need not in themselves be a regulated person, care must be taken to ensure that anything that does constitute a regulated activity under FSMA is undertaken by the operator or another third party with the requisite level of authorization and permissions granted by the FSA.

As an unregulated CIS, investments in the LLP may not be promoted to the general public and may only be promoted to certain categories of investor, who are able to invest in the fund under the financial services legislation, e.g., investors who have been certified as being sufficiently sophisticated to understand the risks involved in such an investment. In addition, as an unregulated scheme, compensation under the FSA's compensation scheme is unlikely to be available.

The LLP fund will usually be promoted using a document called an Information Memorandum, which sets out the parties involved in the fund, the investment strategy of the LLP, the costs of the LLP and a statement of the likely taxation consequences and returns of an investment in the fund. This, together with the members' agreement and any agreements with any promoters and operators of the fund, will constitute the ‘scheme documentation’.

Conclusion

The LLP was the vehicle of choice for most film schemes incorporated since 2001 because of the added flexibility created by the LLP's structure, the existence of limited liability to all members and the tax transparent structure. In addition, and unlike an LP, an LLP permits its members other than the general partner to actively participate in the running of the business of the partnership. However, as word of caution, the way in which investments in an LLP and the running of an LLP are treated for tax purposes by the Inland Revenue is constantly evolving, so that it is always advisable to receive up to date legal and taxation advice on the latest developments in setting up such schemes. In 2004 the Inland Revenue made substantial changes to the rules relating to Film schemes. Therefore, producers should seek professional advice to determine if this type of scheme is appropriate.

Sale and Leaseback Transactions

Although sale and leaseback transactions will come to a close in July 2005, it is worthwhile looking at the scheme because of itsimportance over the last few years to the British film industry. At the time of writing this book, the scheme will be replaced with a transferable tax credit system. Some feel that this type of transferable tax credit system will be similar to the one used in Luxembourg. Check the Department for Culture, Media and Sports (DCMS) website for further details.

Sale and Leaseback

The current UK tax legislation allows for a 100 per cent write off of film production costs for a qualifying British Film in the year of completion or acquisition of the film. The Government's stated objective when introducing such tax deductions was to offer producers a means to reduce the cost of their film production and thus promote production activity in UK.

In order to take advantage of this tax deduction it has become common practice for film producers to enter into a transaction in the form of a sale and leaseback of the film. Several companies in the UK facilitate sale and leaseback transactions, which by virtue of the tax deduction available enable grouping individuals to purchase the film through a partnership.

In order to receive the benefits of a sale and leaseback transaction, a production must be certified as a British Film by the Department for Culture, Media and Sports (DCMS).

In order to access the UK sale and leaseback benefits you will require a UK co-producer if the production is set up as an international co-production.

What is the applicable legislation?

The UK tax write-off is found in Section 48 of the Finance (No. 2) Act 1997. This was added to by the Finance (No. 2) Act 1999 which extended the relief by a further 3 years until 1 July 2005.

There are three conditions to be met before Section 48 applies:

1. the expenditure must be incurred after 2 July 1997 and before 1 July 2005;
2. the total production expenditure on the film must be £15 million or less;
3. the film must be ‘completed’ after 2 July 1997.

The government issues detailed Statements of Practice which should be consulted for any changes.

How are sale and leaseback transactions structured?

The leasing structure developed in the UK enables a qualifying film to be sold by a producer to a partnership. That partnership is a see-through vehicle for tax purposes and enables tax losses to be passed on to the individual partners in that partnership. The partnership then enters into a finance lease, usually for a period of 15 years, leasing back the distribution rights to either the original producer or a third party.

As far as the producer is concerned, the distribution rights will be exploited in the normal way. The only change that has occurred is that the original ‘freehold interest’ that the producer once enjoyed has now been turned into a leasehold interest under a 15-year lease. The figure shows the way in which the structure operates.

The first issue in the figure to note (see 1 on the figure) is that an investor leverages up his investment in a partnership by taking a loan from a bank. The bank will make a full recourse loan to the investor who must make a capital contribution into the partnership consisting of both the loan element (usually approximately 82 per cent of the investment) plus a cash element of 18 per cent.

The lending bank will be concerned that it has sufficient security in order for its loan to be repaid. You will see in the figure(2) that guaranteed rental payments are paid from the producer/lessee to the partnership over a 15-year period. The sale price of, say, £1 million will be paid by the partnership to the producer (3). From the producer's perspective it would be wonderful if that were the end of the story, as he would then be re-financing 100 per cent of his film cost. What happens is that approximately 88 per cent of the £1 million, i.e., £880,000 will be placed in an account at the guarantee bank in the name of the producer but subject to a security interest in favour of the bank. In other words, the £880,000 is in a locked box account. That money will stay there over the 15-year lease term to act as collateral for the 15 annual rental payments made each year by the production company to the partnership.

Under the terms of the lease (4 in the figure) the guarantee itself and the right to receive the rental income is assigned to the lending bank that exactly covers the principal and interest owed by each investor/partner to the bank under each individual loan. The lessee must pay the rent under the lease. In the event of default by the lessee, then the guaranteeing bank becomes liable under its guarantee to make up any shortfall or, indeed, to pay all future rentals as they fall due.

Now, the good news for the producer is that there is still an amount of free cash available once the transaction goes through. In our hypothetical case, 88 per cent has been placed in the locked box account but there is 12 per cent available for distribution to the producer. This is the producer's gross benefit.

What are the costs of the transaction?

From the gross benefit, there are three areas of expenditure the producer must take into account and for which he is responsible:

1. Payment of the guarantee fee to the guarantee bank (referred to in the business as the defeasance bank). Rates that are independently negotiated by the producer are approximately 0.4-0.5 per cent depending on which bank the producer selects. Again, it is a highly important tax principle that the producer must arrange and negotiate the terms of his own guarantee.
2. The producer's own legal fees. These fees have come down over the last couple of years as documents have become more standardized.
3. Certification fees. In order to obtain a British Film Certificate, which is required for a qualifying film and which is issued by the Department for Culture, Media and Sport (DCMS), an external audit must be carried out by an auditor who must produce a cost statement that is submitted to the DCMS. For British films the cost of this is approximately £5,000 but may be considerably more expensive in relation to a complicated co-production between various countries.

How is the sale and leaseback provider remunerated?

The sale and leaseback (S&L) provider takes its fees by charging the investor in relation to its management services. This does not affect the producer's benefit.

What is the definition of a British film?

To qualify as a British Film, a film must be certified as such by the DCMS under the Films Act 1985 (as amended). There is presently no method available to obtain certification prior to completion of a film. In certain circumstances, the acquisition of film rights by the partnership may take place prior to certification being issued if, either: (i) satisfactory evidence has been provided that the film will clearly qualify as a British Film; or (ii) security, in the form of a policy of insurance issued by a completion bond company covering such risk, is obtained in favour of the partnership to be held pending final determination by the DCMS that the film qualifies as a British Film. In general terms, a British Film is a film where:

• the producer was, throughout the time that the film was being made, a person ordinarily resident in or a company registered and centrally managed and controlled in a state of European Economic Area which is a member of the EU (EU member countries are Austria, Belgium, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Poland, Portugal, Slovakia, Slovenia, Spain, Sweden, The Netherlands and UK) or the EEA (European Economic Area - Iceland, Liechtenstein and Norway) or with which the EC has signed an association agreement (Bulgaria and Romania have associated agreements with the EC); and
• at least 70 per cent of the total expenditure incurred in the production of a film was spent on film production activity carried out in the UK; and
• the requisite amount of labour costs represent payments in respect of the labour or services of Commonwealth or European Union citizens, or persons ordinarily resident in a country in the Commonwealth or the European Union (the Isle of Man and the Channel Islands are not part of the UK or part of the EU/EEA for the purposes of Schedule 1. They are part of the Commonwealth. Their citizens are EU nationals; persons ordinarily resident there are ordinarily resident in the Commonwealth).

The percentage of labour costs paid, or payable, to citizens or ordinary residents of a Commonwealth country or member state must be the lesser of:

• at least 70 per cent of the total labour costs after deducting the cost of one non-Commonwealth/member state citizen or ordinary resident; or at least 75 per cent of the total labour cost after deducting the cost of two non-Commonwealth/ member state citizens or ordinary residents, one of whom must be an actor in the film.

Also eligible for relief are films produced under the terms of an official co-production treaty between the UK and another country or under the European Convention on Cinematographic Co-Production (ETS No. 147). Films produced under such treaties represent a growing proportion of British qualifying films.

What about films over £15 million?

Films with production expenditure exceeding £15 million also qualify for UK sale and leaseback benefits. However, the relevant section (S.42 Finance Act 1992) provides a 33 1/3 write-off. Benefits are at a lower level than under S.48.

What rights does a producer give away?

The producer sells the master negative and licenses worldwide distribution rights to the partnership. In order to achieve this, standard form documentation will include a laboratory pledgeholder letter that effectively passes on the ownership of the master negative to the partnership. That is the critical issue for thetax efficiency of this transaction combined with the licence of distribution rights. The licence transfers the worldwide exploitation rights to the partnership by way of licence. However, immediately subsequent to this agreement being entered into, the worldwide distribution rights are leased back to the production company. The way in which the documents are structured means that all of the distribution rights are transferred subject to the prior distribution rights that have already been entered into. However, to complete the documentation, a schedule containing details of each distribution contract entered into prior to the date of the sale and leaseback taking place is needed from the producer.

In addition the producer provides the partnership with a net profit participation. The partnership is in the business of leasing films not only for the rental entitlements under the lease but also to participate in net profit participations or other entitlements in the film. Therefore, on a case-by-case basis, the partnership will negotiate a profit participation with the producer in addition to the rental income. While the rental income is secured by bank guarantee, the profit participation is unsecured.

What costs are allowable in calculating production expenditure?

The UK does not have a formal accounting standard covering the film industry. However, production expenditure should, nevertheless, be identified by reference to normal accountancy principles, subject to the specific issues outlined below. It is not possible to list comprehensively what constitutes production expenditure. What follows is a guide.

• The cost of underlying rights used for a film;
• salaries, fees, benefits (and living expenses) and all associated costs (such as NIC and payroll taxes) of people involved in the making of the film, including payments to foreign nationals. This will include for example: all those employed in directing and producing, technical and industrial capacities, extras and miscellaneous staff; a relevant per cent of stills photographers and those engaged in processing and titling, etc., pro rata to the work done on the film;
• studio costs wherever they are situated and all studio labour costs, as they actually relate to the production of the film;
• cost of set construction and operations;
• wardrobe and all accessories;
• cost of sound synchronization;
• production overheads attributable to the film;
• location costs, including the rental of facilities on location and the costs of taking the unit to the location.

Certain costs are incurred during the final production phase and the release periods of films (sometimes termed exploitation costs) that are not related to the actual completion of the master negative. Examples of such costs are film prints, advertising, rents, salaries, and other distribution expenses. The Inland Revenue does not consider that these types of costs should be included as production expenditure.

Interest on money borrowed to finance production should be relieved for tax purposes in accordance with the normal rules for Case I/II of Schedule D (and via the loan relationship rules for companies), and should not be included as production expenditure. Similarly, any other costs connected with raising and servicing finance to make the film should not be included.

Both deferments (i.e., monetary amounts payable out of receipts from the film) and participations (i.e., percentage amounts payable out of receipts) are contractually due to producers, directors, actors, etc., but that are not paid in the course of production should normally be included as production expenditure, provided the deferment will be paid within 4 months of completion of the film. However, very strict rules exist regarding deferments and they need to be reviewed in detail.

Capital expenditure on the provision of assets such as film cameras, lights and sound recording equipment may be employed in the process of production, but which are not fully used up in that process, should not be regarded as production expenditure for the purposes of these provisions. In these circumstances the capital allowances rules may apply.

Sale and leaseback - a case study

Transaction

The Producer, a UK company, sells a film to a partnership for, say, £10 million and enters into a 15-year lease.

Invoicing

1. Producer issues an invoice to the partnership for £10 million +VAT @ 17.5 per cent ( =£1,750,000).
2. The partnership invoices producer for all 15-year lease payments for, say, £13 million +VAT @ 17.5 per cent ( =£2,275,000).

Treatment of VAT on above

VAT applies where the seller/lessee is a UK company. In the above example, the producer is therefore in a net VAT payable position to the partnership of £525,000 ( =£2,275,000 less £1,750,000). If there is perceived to be a credit risk to the partnership, part of the benefit from the transaction payable to the producer may be escrowed until the VAT works its way through the system.

Cash movements

Purchase price: £10,000,000
Amount placed on deposit by producer at guarantor bank to
guarantee lease rental payments: (£9,000,000)
Gross benefit to producer (12.0 per cent): £1,200,000
Guarantee cost (estimated at 0.45 per cent): (£45,000)
Legal: (£5,000)
Audit: (£5,000)

Net benefit: £1,145,000

What about a film that has already been released?

Paragraph 70 of the Statement of Practice states that ‘where a film is sold prior to general public release for a sum equal to production expenditure … the Revenue will not seek to challenge the price … This also applies where there is a pre-release agreement and the sale takes place within three months of release’. So, in most cases, the S&L must take place prior to release. However, it is also open for a partnership/lessor to purchase a film on the basis of a valuation, i.e., without relying on the provisions of paragraph 70. A valuation may be carried out, i.e., valuing unsold territories over the period of the lease term (i.e., 15 years). Provided the film qualifies as a British film under the Films Act and the valuation is carried out by a professional valuer acceptable to the partnership, utilizing an appropriate methodology, catalogue material produced after 2 July 1997 could be re-financed in this way.

How do I get a British Film Certificate?

For a film to be certified as a qualifying British film by the Secretary of State for Culture, Media and Sport, it must fulfil either the conditions set out under Schedule 1 to the Films Act 1985 or the terms of an international co-production agreement to which the UK is party.

Films cannot be certified before they are completed.

Auditors’ report

The Films Act requires a report to the Secretary of State verifying the particulars of salaries, wages and payments, prepared by an accountant who is a member of a body of accountants recognized under section 25 of the Companies Act 1989, who is not and was not at any time while the film was being made, a partner of, nor in the employment of, the maker of the film.

The auditors' report should include the following wording:

The auditors’ report should be addressed to:

The Secretary of State for Culture, Media and Sport

Department for Culture, Media and Sport

2-4 Cockspur Street

London SW1Y 5DH

UK