13/09/2010 - This paper sets out the rationale for creating a UK Government film fund using the proceeds from the film tax credit ceasing to be free and instead becoming recoupable and entitled to a profit share

Background

Film is the flagship of the UK’s creative industries, but suffers from deep rooted market failure due primarily to lack of scale in its home market (only the US, Indian and Chinese markets have sufficient scale to support their film industries). Nevertheless, the UK has two major competitive advantages in its language and the renowned quality of its filmmakers, cast, crew and service providers.

Broadly, the film industry consists of two sectors: (a) the service providers such as post production facilities, physical studios, visual effect houses etc. and (b) the independent producer community. The first group is part of a global market competing for work on U.S. studio productions and currently much in demand because of its quality and the film tax credit incentivising the studios to base their films here; the second group is a fragmented cottage industry consisting of producers of vastly differing ability, all competing to find money to finance their individual film projects.

Most of this finance comes from offshore (typically a US studio or other foreign distributor) so any profits arising from exploitation of UK films return to the origin of the finance and are taxed in that jurisdiction - none of the upside remains in the UK. The erstwhile aim of creating a sustainable and thriving home grown production business to sit alongside the buoyant services sector therefore remains illusive.

In section 48 of the Finance Act (No. 2) 1997, the Chancellor introduced the ability for a private investor to deduct the cost of acquiring a British film from his individual tax liability, via a so-called sale and leaseback. A similar piece of legislation (section 42 of the Finance Act (No. 2) 1992) already existed but the deduction could only be claimed on a straight line basis over 3 years. Section 48 however allowed the deduction to be claimed in year one (but only on films below £15m). This stimulated a wave of private investment into the UK film business through partnerships of individuals, but was in fact a false dawn. Notwithstanding the benefit to the services sector from increased levels of production, the sale and leaseback mechanism was inefficient, complex and open to abuse. Moreover, the investors did not take performance risk on the films. Success or failure was irrelevant because investors simply received a tax deferral, to be paid back over the life of the film lease irrespective of film performance, while the producer used his benefit from the transaction to defray the cost of production. It was a purely financial arrangement which did not achieve the policy aim of creating a sustainable business.

It did however set the scene for investors to move further up the risk curve and the next generation of film partnerships did take performance risk, while using sideways loss relief (“SLR”) to protect the downside. The quid pro quo was that the partnerships’ income from film exploitation was taxable in UK, so that in success the Treasury would be better off because the tax paid on income would exceed the initial tax relief. In the long run, this could have made a lasting difference to UK producers, but was also open to abuse and despite Conservative-supported attempts to preserve SLR by introducing a purpose test and a pre-clearance procedure, SLR was eventually restricted to “active” investors. In 2007, the film tax credit was introduced in place of s.42 and s48 and in contrast offered a cleaner, simpler mechanism delivering greater value to producers with fewer professional fees to pay along the way.

Combined with the current $/£ exchange rate and the quality of UK service providers, the tax credit makes the UK an attractive and compelling destination for US productions (for which there is global competition). However the vast majority of UK independent producers continue to struggle, because despite the value of the tax credit, the balance of their film budgets is harder to raise than ever. Therefore the UK remains in essence a glorified service provider, with nothing to fall back on if the US studios shift their business elsewhere.

The Proposal

The film tax credit is currently non-recoupable and non-profit sharing but there is no reason why this should be so. It helps protect the downside for a film’s financiers and leverage their returns – in simple terms, a 16% tax credit means that a film costing £100 only needs to find £84 in risk capital, so its backers are reducing their risk by £16 at no cost (they do not share any upside with the provider of that £16).

In the commercial world and in any other walk of life, that £16 would command a return and the project would expect to pay it. There is no convincing reason for film to be any different. Instead, there is an expectation formed by years of habit that government support should be free to the film industry, but this must change.

The US majors have enjoyed the benefit of our tax credit on some hugely successful films. They would argue that in return they have contributed millions of pounds to the UK economy, which is true but the world has changed, for everyone.

The major studios (Fox, Disney, Sony, Warner & Universal) are all part of larger media conglomerates and have corporate parents with a keen eye for fiscal responsibility and the bottom line.

Film production is a hit-driven, capital intensive business with volatile and unpredictable returns. Were it not for the need to feed their distribution networks and keep their libraries refreshed, some studios would happily avoid the risk inherent in production altogether, but the stellar returns from new hits together with library cashflow cover the misses.

These returns (and the perceived glamour of film) have attracted investors from time immemorial but outside investment in studio films went into overdrive in the boom decade as excess liquidity in the market sought a home and investors became sold on film as an attractive alternative investment (it’s recession resistant and uncorrelated to the stock market). For their part, the studios (and in particular their parents) welcomed this influx of co-finance because it allowed them to lay off risk and spread their own capital across a larger number of films, thereby creating more product for their distribution networks and increasing the chances of a hit (the portfolio approach at work).

As a result of the credit crunch however, the studios will not have access to the same level of co-finance going forward, but have become dependent on it and their parents expect it. They have reduced their output but their films are now more expensive than ever, as they seek to deliver a technology driven entertainment experience that audiences cannot find anywhere else (e.g. TV, online, mobile, video games etc).

We are not proposing that the UK Government should position itself alongside professional investors. Rather, the point is that the studios need capital and will pay for it, so the tax credit does not have to be free. The studios will argue that asking for any kind of return will undermine the UK’s appeal as a location. We disagree. Certainly there are other jurisdictions with attractive incentives, but every incentive programme has its limits. Looking at the UK’s position as a production centre, the country has a strong hand and should play to it. In today’s cash-strapped world, “soft equity” is a valuable commodity for studios and producers alike.

For the studios, we would propose recouping the tax credit after the studio has recovered its own outlay and then also receiving a profit share. This type of “second position” deal will still be attractive to the studios and gives HM Treasury a chance of recovering sizeable amounts. A similar arrangement could be applied to independent films although the multiparty nature of their financing structure will generally necessitate last position for recoupment (but still with a profit share). These arrangements should be overseen by a professional investment house.

The Fund

With these returns, UK Government could offer additional support to UK independent producers in the form of a matching fund intended to help producers of successful films grow their businesses and strengthen the creative sector.

Simply put, the fund would provide producers of eligible films with matching equity finance on terms that help them both finance their films and participate in a greater share of upside.

By way of example, if the producer of a film costing £100 has a private investor who is willing to invest 30% of the budget in consideration for a recoupment position and profit share, the fund would contribute the same amount of equity on the same terms, such that both parties are treated equally. Once the fund has recouped its investment, it would split its profit share with the producer, thereby providing the producer with additional capital to reinvest in his business.

In order to make sure that the fund is not wasted on films with little or prospect of profit, a strict set of eligibility criteria will be necessary and should include the following in order to direct the fund’s support to British films with commercial appeal:

The film must satisfy the same cultural test as the UK tax credit; . The film must have a UK pre-sale to demonstrate appeal in its home market; and . The film must have international distribution in place either with a US studio, or with a 1st class international sales company who has pre-sold the film to at least two major territories in order to demonstrate appeal to the international market.

No set of criteria will be perfect, so the fund will inevitably require discretion to reject films in certain cases in order to prevent abuse.

As with the recoupability of the tax credit, the fund should be managed by a professional investment house with experience in the sector.

Issues The UK film industry is hard to please, so despite the economic imperative and the obvious benefits to commercially minded producers, there will be objections, such as:

Objection: The previous government’s constant tinkering created uncertainty, prevented confident forward planning and made the UK less attractive as a film-making destination. The tax credit is bedded in and is working well, so why change it?

Answer: we are now in a completely different fiscal environment and the tax credit in its current form does not represent good value for taxpayers. Furthermore the creative industries are a highlight of the UK economy and this innovative additional financial support at no further cost to the taxpayer will help under-resourced UK filmmakers develop their commercial potential and promote further growth in this key sector of our economy.

Objection: Managing both the recoupment aspect of the tax credit and a fund of this size is considerable additional work. Who will do it? Are UKFC properly equipped? Answer: An experienced professional investor would be appointed after a tender process. There will be a cost to this, but it will be covered by the revenues generated from the tax credit and the fund, so as above, there is no additional cost to the taxpayer.

Objection: The service providers are heavily dependent on US studios and will suffer if the studios desert the UK as a result of this. Why would they stay? Answer: Although the tax credit will no longer be free, it is still a cheap source of co-finance compared to the studios’ usual co-investors, who in any case have less appetite today as a result of the downturn. Furthermore, we have to change the dynamic here and wean our film industry off its dependency on the US studios if it is ever to become self-sustaining. The UK has a huge talent base which it currently either exports or rents out to the US. This would change if UK film makers could strengthen their capital base through our proposed fund and sustainability might then become a reality instead of an illusion;