Since 1999, following a change in German tax laws, investors in Media Funds have been permitted write off 100% of an investment against their taxes in the year the investment is made. This immediate deduction makes these Funds a very attractive option for thousands of well-heeled private investors looking for tax shelter. It is estimated that investment capital from German Media Funds was US$1.6 billion in 2002.
For a number of reasons, the vast majority of the monies raised by German Media Funds have been accessed by U.S. Studios. Some observers estimate that up to 20% of Hollywood’s aggregate yearly production budget over the last couple of years has been supported by these German sources.
One of the key reasons for the popularity of the Funds with Studio’s is the absence of any German spend requirement– hence the use of the terms "silly money" or "stupid money" often used to describe this soft money source.
Since the German tax authorities have not issued any advance rulings on Media Funds the practices of each of the Funds will vary depending upon the specific tax advice they have received from their advisors. Since each Fund has its own particular nuances, talking about them in anything other than general terms is difficult. Accordingly, this document should not be taken as covering all aspects of all of the Funds which are available.
2. General Structure
Typically, a Fund, after agreeing to become involved with a specific project, will enter into a series of documents which accomplish the following:
- The Fund acquires the underlying rights to the production from the Studio/Producer entity.
- The Fund engages, pursuant to a production services agreement, a production services company under a work for hire arrangement to produce the production in accordance with a Fund-approved budget. Under this agreement, the Fund is responsible for funding 100% the costs of the production.
- The Fund enters into distribution arrangements pursuant to which it grants world-wide distribution rights in all media in the production to a distributor1.
- The Fund enters into arrangements with the Studio/Producer which contemplate the transfer of the rights in the production back to the Studio/Producer at the end of the term of the Fund’s existence2, which is usually between 7-9 years.
Each of the existing Funds each employ slightly different structures, however, there are broadly speaking, two types of Funds: (i) guarantee; and (ii) risk. More detailed descriptions of these types can be found in Exhibits "A" and "B" attached hereto. In both types the Fund cashflows 100% of the budget of the production and offers a net benefit of approximately 20% of the production budget to the Studio/Producer in exchange for the Studio/Producer entering into the series of documents noted above. Under German tax law, as long as the Fund is the producer3 of the production, its investors are allowed to deduct 100% of their investment in the Fund.
What is important to note is that regardless of which type of Fund is accessed, the producer must have the resources to bring approximately 80% of the budget to the table in presales, guarantees or letters of credit. This requirement underscores why Media Funds have been primarily accessed by U.S. Studios, and much less so by independent producers.
3. Recent Developments
The German government has expressed its desire, given the state of the German economy, to eliminate all forms of leakage from the tax system, including the tax deferrals offered to investors in these Funds. In addition, the Funds have come under closer scrutiny by the German tax authorities as a result some overly optimistic (i.e. inflated) rates of return promised to investors by several funds over the last couple of years. As a result, the commercial viability of a project has become key issue for Fund initiators when choosing which products they will acquire.
As a result of the most recent revised German Media Decree (issued in August 6, 2003) certain funds are required to form an "advisory board" comprising investor representatives once at least 50% of the planned capital has been raised4. The purpose behind the changes is to allow investors to be involved directly in the decision-making process on all essential measures of film production, particularly the choice of film subject, screenplay, the cast, the calculation of the costs incurred, the shooting schedule and the financing. It remains to be seen how much influence these advisory boards actually have and what the reaction will be from the U.S. Studios.
4. Canadian Content5 and Co-Productions
While there was some hope that the revised Media Decree would have included guidance on the issue of international co-productions, no such guidance was set out. We had discussions with lawyers and accountants who act for various Funds on the topic of accessing these structures for Canadian content or treaty co-productions. We did not get any comfort that these types of productions would be able to successfully access the German Funds. The main issue is the requirement that the German Fund own 100% of the copyright from inception, and for the term of the Fund’s existence. The people we spoke to indicated that they had done some research on this issue in the past, but they were not convinced that a Fund could participate on either a Canadian content show or a Canadian treaty co-production.
5. Accessing a Fund
All Funds require the following information before they make a decision on any project; (a) full budget (which they will have reviewed by experienced line producers); (b) a copy of the script; (c) attached cast; (d) sales estimates from a reputable sales agent; and (e) details of the financing and pre-sales7.
Since the Funds have historically had more product available than investors, they feel they are in a position to be able to pick and choose projects, although I suspect that this position tends to be somewhat more flexible as December 31st approaches, and the Funds want to place their investor’s money. In order to maintain the tax deduction for their clients, the Funds must place the money they raise into the account controlled by the production services company or a completion bonder by December 31st.
In order to lock-in financing from a Fund this year, the following documents are required by December 31st, 2003:
- A rights assignment to the Fund;
- A production services agreement;
- A distribution agreement;
- An assumption agreement – in certain guarantee Funds; and
- A completion bond (or in some cases, fund will accept a letter of intent from the bonder).
In addition to the foregoing, the production must start principal photography by no later than June of 2004 – there may be some cases where that doesn’t happen, and also the rare case where the picture simply doesn’t go forward. From a Fund’s point of view, the latter eventuality is a potential disaster because of the impact on its investors.
Guarantee Funds typically employ a structure wherein the future payment obligations of the distributor of the production are secured by a deposit of cash at a bank.
Under the transaction, the distributor is obligated to provide, at closing, an amount equal to 80% of the budget. On closing the Fund pays 100% of the budget to the production services company and receives back the amount of 80% as security for the obligations of the distributor, which amount is then deposited at a bank. Typically the future payment is equal to approximately 100%-105% of the production budget, and is satisfied by the 80% deposit which, at maturity (including accrued interest), should equal the payment obligation. In some structures, the distributor has an obligation to make guaranteed yearly payments (called variable licence revenue) to the Fund, and these payments are also secured by the deposit.
The so-called "waterfall" of payments will typically see net revenues equal to 115%-125% of the production budget (inclusive of the 80% above) go to entirely to the Fund. Thereafter, net revenues are split with the production services company on a negotiated basis8.
The VIP III Fund is slightly more aggressive in its recoupment position as it requires a 4% gross window on first dollar gross from the U.S. during P&A recoupment, and a 4% gross window from foreign after recoupment of the P&A.
The "risk" type of Fund does not utilise a bank deposit, but does require that there are bankable guarantees or a letter of credit which equal 80% of the production budget9. Each risk Fund will vary somewhat, however, to illustrate generally how they operate, below is what is required by Equity Pictures:
(i) 60% of the production budget as follows:
- 55% of the production budget as a loan from Comerica Bank (or some other approved lender); and
- 5% of the production budget as an L/C payable 6 months after delivery of the production.
(ii) 20% of the production budget as a corporate guarantee which is payable in the 18th month10 after delivery of the production in the event that the production has not returned 80%.
The waterfall, while generally negotiable, will see the first net revenues equal to 120% of the production budget (inclusive of the amounts in (i) and (ii) above) going to the Fund (allowing for deductions in favour of the collection agent and residuals). Thereafter, net revenues are split with the production services company on a negotiated basis11.
1. It may be the case that the distributor cannot be the same entity that rendered the production services to the Fund – this is dependant on each Fund’s tax advice.
2. In some cases, the price to be paid for the rights can be negotiated, and in other Funds it is a fixed amount – typically 10% of the budget of the production.
3. There are certain indicia of who the producer is for German Tax purposes, including without limitation, ownership of 100% of copyright from inception; making of essential decisions and the bearing of financial risk. As noted herein, the Fund does not actually produce the movies, but rather it hires a production services company on a work for hire basis.
4. This may present a timing problem for the Funds, which traditionally do not hit the 50% mark until mid-November, thereby giving them a little over a month to choose product.
5. As used in the CAVCO sense.
6. Many of the Funds will be looking for sales estimates which demonstrate that the production will be able to generate revenues of 120% on a mid-case performance scenario
7. Some Funds will require that at least U.S. distribution rights have been sold.
8. An example would be as follows ; (i) up to 115%- all to the Fund; (ii) 115% to 130%- Fund 70 /Producer 30; and (iii) over and above 130%- Fund 60/ Producer 40.
9. We were informed about a deal done involving Living Pictures Fund, an independent producer and the typical structure of numerous pre-sales. The Fund had a very difficult time dealing with the various sales, and has expressed a strong preference in dealing with just an L/C.
10. This timing may be negotiated out to 24 months for some risk funds.
11. See note 8 above.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.