1. How does the tax deduction work?
There is a general rule under the German Commercial Code (HGB) that in financial statements no value may be attributed to self-created intangible goods constituting fixed assets. This has the effect that all expenses incurred in creating such goods are immediately generating a loss as they are not made good by a corresponding book entry in the assets shown in the balance sheet. All future income, on the other hand, will be treated as taxable income as there will be no write-offs or depreciation since the value of the film produced in the balance sheet is nil.
According to a decision by the Federal Tax Court, a film is to be deemed an intangible good as its value goes well beyond the mere value of the master negative.
2. Why is this concept interesting for German tax payers?
Assuming production cost is one hundred and the average individual tax rate of German tax payers is 50%, then the tax reduction in the year of production will be 50. The actual money at risk is therefore reduced to only 50.
If the film turns out to earn money and if the arrangements provide that the bulk of that money is payable to the investor only some years later, such receipts will be taxable again but there will at least be an interesting tax deferral effect.
3. Is this tax scheme only available if the film is produced in Germany?
The answer is no, as it is not a tax scheme intended to support German or European film production, but rather a general principle of German accounting and tax law. It is therefore possible to use these structures to produce German and European as well as US productions. It is available for theatrical films and television productions.
4. What is the size of the German film fund market?
After film funds had almost vanished at the end of a first wave in the late 1970ies, film funds have been marketed again in a relevant way since 1997. Last year (2001) film fund investments were offered in a total amount of EUR 3 billion. The total investment into closed funds (consisting of media funds, real estate and ship investments) reached some EUR 10 billion. Out of the total film fund investments probably only EUR 2 billion were actually placed, which compelled a number of placement guarantors to step in and to take over a part of the funds for which they had issued placement guarantees. This experience is likely to make it very difficult to obtain not just best efforts undertakings from German arrangers, but hard placement guarantees.
5. Why is the German government not trying to reduce such tax benefits?
Over the years the German government has actually been trying to stop unwanted developments by taking a number of measures, such as:
a) Losses claimed by the investors cannot be higher than their actual liability.
b) Participations offered by an arranger on the basis of a model investments such as a prospectus or offering memorandum may not provide for after-tax profits to be more than double the pre-tax profits. The possibility to use additional bank financing to leverage the tax benefits is hereby reduced. However, this restriction does not apply to individually conceived investments.
c) For each individual tax payer the full deductibility of losses from other sources of income is limited to EUR 50,000; any excess loss may only be deducted from other sources at a reduced level.
d) Any loss attributable to a foreign permanent establishment can be set off only against profits of the same kind stemming from the same territory. This is why co-productions can be very unfavourable in terms of German tax as losses created by them may not be deductible if attributed to a foreign permanent establishment, whereas the German co-producer’s income may be fully taxable in Germany.
e) In order to allow any tax deductibility, the tax payer must finally be able to show that it had reason to expect an overall profitability of the investment. This can be proven either by summing up the minimum guarantee instalments payable over the course of time by the distributor and/or by producing a well-founded (usually third-party) judgment of the selling potential of a film project. These projections have to cover not just the production cost, but also the costs incurred to set up the structure, inclusive of the costs to raise the equity. If this test can only be met based on projections, there remains the risk that a later tax audit will not accept these projections as sufficient proof, as has been the case with a number of film funds of the late 1970ies.
6. If these restrictions are already contained in the general body of the tax law, what is then the purpose of the Medienerlass usually translated as Media Decree, Media Ordinance or Media Tax Guidelines?
Tax guidelines are issued by the Ministry of Finance after consultation with the Finance Ministries of the German Laender. The media tax guidelines were intended to set out the requirements for film funds to qualify as producers of a film, and for the investors to benefit from such status. Beyond its original scope it also contains clarifications as to the depreciation period of acquired film rights and the tax treatment of co-productions. The Media Tax Guidelines, however, are not creating new regulations, but constitute only an interpretation of the existing laws. They are binding on the tax administration, but not on the tax courts.
7. What are the most relevant elements for a film fund to qualify for a positive tax treatment under the Media Tax Guidelines?
a) In order to be the producer of a film, the fund has to acquire all rights in the underlying material and must have the possibility to exercise control over the production with respect to organizational, financial and major creative issues.
b) The fund may use a production service company which will be responsible for carrying out day-to-day production work on a work-made-for-hire basis.
c) The production service company may be related to the distribution company.
d) It will receive a fixed fee for its services, but should not have a profit share.
e) Even if production takes place abroad, the fund will not be deemed to have a permanent establishment at the domicile of the production service company.
f) The fund does not have to develop the project itself, but may acquire a production package ready for shooting. However, it should do so not later than by start of principal photography.
g) The fund may prepay production cost to be incurred by the production service company the following year already at the end of the preceding year, and may treat this prepayment as expense when paid, if it is not entitled to reclaim such prepayment.
h) Investors have to join the partnership at a time when they are theoretically in a position to still exercise a relevant influence on the production through the partnership. It is the common understanding that this may still be the case after start of principal photography, but it should definitely occur prior to the end of principal photography.
8. What kind of security are German investors looking for?
There are two basic types of funds:
a) In the first scenario resembling a sale & leaseback type of transaction, the distribution company undertakes to make fixed payments to the fund, which over the course of time exceed the total investment of the investors including the soft costs they have to pay for creating and sustaining the structure. Such fixed payments usually coincide with a limited upside potential in case the picture performs extraordinarily well.
b) In the second scenario (so-called risk funds) the fund offers as security only a certain amount of presales, which some years ago were in some cases backed by shortfall guarantees. The gap will then hopefully be recouped from further sales and overages. As this is a difficult pitch for investors the distributor, also in this second model, usually undertakes to make minimum guarantee payments over the course of the years for some 70-90% of production cost. The upside for the investors is higher here, and distribution fees will be reduced until the fund has earned 130 to 160% of its investment.
In both these scenarios any distribution guarantee payments are often defeased with a German bank assuming the fixed payment obligations against payment of an assumption fee in the amount of the net present value of the fixed payments.
Blind pools in which the projects are not specified are said to be difficult to place. In risk funds portfolios are preferred over single picture investments.
9. How much does it cost?
This depends on who will be marketing the investment. The banks will usually take only high-end products with a tight security net for the investors. The soft costs, i.e. the overall cost to create the structure and market the investments, will be in the area of 10 to 13% for this kind of product. If the fund has to go to the so-called grey market, with independent sales teams shopping the investment to doctors, lawyers, heirs, widows, etc. the soft costs, however, may go up to 20% and more. These additional costs will have to be earned back in order to provide for an overall profit to the investor.
10. What is the benefit of this (costly) undertaking for the foreign producer?
a) There is usually a comfortable production service fee of some 10% or even more.
b) If a risk fund invests in the picture, this will allow the original producer to close the gap of the financing.
c) In a fully defeased leasing-type structure the net benefit for the original producer will be some 10% of production cost, varying according to the respective interest rates.
d) The upside sharing is relatively modest once the fund has earned back all its cost plus a small profit.
e) By a put-and-call mechanism the rights can usually be obtained back by the distribution company affiliated with the original producer after the fund has expired.
11. Can this German tax structure be combined with a UK sale & leaseback?
Yes, in principle this works. It can happen in a co-production structure, via the production service company, or via the distribution company.
12. What will happen this year (2002)?
a) There is a chance for a revision for the Media Tax Guidelines with respect to co-productions.
b) The number of individually structured deals with only one or very few investors will probably increase as these deals allow for greater tax benefits.
c) More and more of the first funds will have to publish their performances up to date. It is very well possible that many of them will not meet their forecasts, which would have negative effects on the market.
d) Two new decisions by the Federal Tax Court cast general doubt on the deductibility of losses stemming from entering into a package of pre-determined contracts establishing the partnership; the costs incurred by the investor would then have to be treated as acquisition costs for the partnership interest and would only be depreciated over the course of 50 years.
e) Thus there is a lot of uncertainty in the market as to how much it will be able and willing to absorb. Placement guarantees will be more difficult to obtain.
13. Does the new German Copyright Act increasing the protection of authors and performing artists have any impact on film funds?
There is no specific impact since the new German copyright provisions will be applicable to all productions to the extent they are exploited in Germany. The applicability will not depend upon the producer being a German entity.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.