U.S. Financial Bailout Brings New Amendment To Section 181 for the Deduction of Film Costs

Increase in Deduction

The $15 million ceiling on the Film Deduction is increased to $20 million if the Film Costs are “significantly incurred” in certain designated low-income communities. The regulations provide that this test will be met if either: a) at least 20% of the total production costs relating to first-unit photography occur in such areas; or b) at least 50% of the total number of days of first-unit photography are shot in such areas. The preamble to the regulations states that the production costs for the first unit include the compensation paid to actors and directors, but it is not clear whether a portion of their compensation should be allocated to rehearsals or pre-production activities.

Requirements for Qualified Audio-Visual Work

There are a number of requirements in order for an audio-visual work to be a Qualified Audio-Visual Work.

• Television: For television, only the first 44 episodes of any particular series will qualify.
• U.S. Costs: Seventy-five percent of the “Total Compensation” relating to the audio-visual work paid for services performed by actors, directors, producers, writers, composers, choreographers, casting agents, camera operators, set designers, lighting technicians, make-up artists and other persons directly involved in the production of the film, whether employees or independent contractors must be paid for such services rendered in the United States (“U.S. Compensation”). There is no requirement that the individuals be U.S. citizens or residents. The definition of the United States does not include its possessions, such as Puerto Rico. For both Total Compensation and U.S. Compensation, deferments, participations and residuals are excluded.
• Content: The audio-visual work cannot include a “depiction of actual sexually explicit conduct.” Other than this one limit, there are no other limits as to content, so Sec. 181 applies to news, sports shows, reality programs, game shows and commercials. It appears that Sec. 181 would include video games, but the regulations do not expressly include them.

Costs Subject to Film Deduction

• Film Costs: The Film Deduction applies to all Film Costs, discussed above, so it is not limited to U.S. Compensation or even to production costs. For example, it would apply to the entire cost of producing Monday Night Football, including the cost of acquiring the underlying rights.
• Development and Preproduction Costs: The regulations permit the current deduction of all costs, including development and pre-production costs, relating to a film if: a) the taxpayer reasonably believes that the film will ultimately be a Qualified Audio-Visual Work; and b) the film has been set for production (referred to in the industry as “greenlit”). However, the deduction of these costs must be recaptured as ordinary income in any subsequent taxable year during which both these requirements are no longer met.
• Financing Costs: The regulations treat all costs relating to financing the film as Film Costs, including completion bond fees. This may apply to the costs of doing a tax-shelter financing transaction under Sec. 181 itself, because such costs relate to financing of the film.
• Acquisition Costs: The regulations permit all costs of acquiring a film prior to the date the film is released to qualify as Film Costs. Thus, a Sec. 181 financing transaction could shift the deduction to a new taxpayer any time prior to release of a film.
• Reformatting Costs: The regulations state that Film Costs do not include the costs of reformatting a film for release in a different media or territory after the initial release, such as costs incurred in preparation of a DVD version after the theatrical release or subsequent dubbing costs for a foreign country.

Film Deduction Limited To Owner

• Must be Owner: Only the taxpayer that owns the Qualified Audio-Visual Work for tax purposes (based on owning the benefits and burdens of the work) and pays the Film Costs can take the Film Deduction, even if the owner pays an independent production company to physically produce the work. Thus, the deduction applies to the taxpayer that is otherwise required to capitalize the Film Costs. It is not entirely clear just what the taxpayer has to “own.” It is probably not necessary to own the copyright; ownership of distribution rights should suffice because that is the real value of a film. However, the regulations state that a taxpayer that obtains only a “limited” license or right to exploit a film does not have the requisite ownership, but there is no definition of just what “limited” means.
• Subcontracting Production: There is no requirement that the owner be the actual producer of the Qualified Audio-Visual Work; the owner is entitled to the Film Deduction even if the owner pays an independent film production company to physically produce the film.

Election

The taxpayer is required to make a binding election to deduct the Film Deduction in lieu of normal income-forecast amortization with respect to each particular Qualified Audio-Visual Work. The election must be made by the due date (including extensions) of the tax return for the first tax year in which qualifying costs for such work could be deducted. As mentioned above, this is the year that: a) the taxpayer pays or incurs costs for a film that it reasonably believes will ultimately qualify under Sec. 181; and b) the film has been set for production. Any Film Costs for that film that the taxpayer has capitalized in prior years become deductible in the year the election is made. If the election is not timely made, the election is lost as to that film, so the election is “use it or lose it.” The election is made by the owner of the film (even if a pass-through entity) and by the parent of a corporate consolidated group. The election is utilized by deducting the Film Costs on the tax return and by attaching a statement to the return setting forth certain information required by the regulations.

If the film subsequently fails to qualify as a Qualified Audio-Visual Work or if the taxpayer subsequently revokes the Sec. 181 election, the taxpayer must report as ordinary income the net benefit it obtained under Sec. 181 compared to the result if that section had not applied.

Other Tax Provisions

More important than what is written in Sec. 181 is what is not written, since taxpayers must consider all the other provisions and doctrines of existing tax law, some of which are discussed below.

Alternative Minimum Tax

For individuals, as long as the production activity constitutes a trade or business, the Film Deduction will be deductible for purposes of calculating the alternative minimum tax. It thus becomes critical to determine whether the particular production activity constitutes a trade or business. Although there is substantial conflicting law on this question, it is likely that production activities alone, even prior to the receipt of income, will be treated as a trade or business, so the Film Deduction should not subject individuals to the alternative minimum tax.

For corporations, if the Film Deduction is deductible for purposes of calculating “earnings and profits,” the deduction will not subject them to the alternative minimum tax. Because there are no special rules for treatment of the Film Deduction in calculating earnings and profits, it appears that the Film Deduction is deductible for purposes of calculating earnings and profits, and thus should not trigger the alternative minimum tax for corporate taxpayers.

Passive Loss Rules

If the production activity constitutes a trade or business, as seems likely to be the case, the Film Deduction will be subject to the passive loss rules with respect to certain taxpayers, including individuals and personal service corporations. C corporations that are more than 50% owned by five or fewer individuals (“Closely Held Corporations”), and that are not personal service corporations, cannot use passive losses to shelter investment income, but can use passive losses against other income. The passive loss rules do not apply to non-Closely Held Corporations.

Individuals and personal service corporations that do not “materially participate” in the activity can only deduct passive losses, including the Film Deduction, to the extent of “passive income,” which generally is limited to income from real estate and from passive interests in businesses held by pass-through entities. Passive income also includes income from the Qualified Audio-Visual Work. If the Film Deduction is restricted under the passive loss rules, the excess carries forward and may be deducted when it is “freed up” by future passive income or upon disposition of the taxpayer's interest in the activity.

At-Risk Rules

For individuals and Closely Held Corporations, the Film Deduction will also be subject to the at-risk rules. Under the at-risk rules, the taxpayer may only take a deduction for direct investment and borrowed amounts for which the taxpayer has ultimate direct recourse liability. For example, if any portion of the Film Deduction is funded with debt, the taxpayer must have ultimate liability for that debt directly to the lender, without a right to reimbursement from any third party. Such a liability will be included in the “at-risk” amount even if the risk is ameliorated with future license payments from a creditworthy licensee.

Case Law Limitations

Tax shelters based on the Film Deduction need to comply with limitations imposed by case law, including: (a) the taxpayer may need a profit motive; and (b) the transaction must not be vulnerable to being recast based on the doctrine of substance over form in a manner that would eliminate the tax benefits.

Recapture

As originally drafted, Sec. 181 did not require “recapture” of the Film Deduction as ordinary income if the film was later sold, so it was possible for the full amount of the gain on the sale to be long-term capital gain if the film was sold after one year. However, a technical amendment eliminated this benefit and subjects the Film Deduction to recapture at ordinary income rates.

Tax Shelter Financing

Most people assumed that Sec. 181 would operate the same as similar tax provisions in foreign countries, which are usually used as part of sale-leaseback transactions to net the film production about 10% of the budget of the film. However, this benefit is created from “double dipping” on these cross-border transactions, where both sides of the transaction (each residing in a separate country) claim the right to deduct the cost of the film applying their own tax laws. The problem with Sec. 181 on this score is that any film company using it is subject to tax in the U.S., so there is no cross-border double-dipping opportunity. Thus, whatever Sec. 181 giveth on the one hand (deductions given to investors), it taketh away on the other (the deductions from the film company). The film company may raise 10% of the budget from investors under a Sec. 181 deal, only to find that it is now taxed on 100% of the gross receipts, such as pre-sales, without any offsetting deduction for production costs.

It is possible to avoid this problem with advance structuring, and we have closed a number of Sec. 181 transactions that are backed by large banks (which avoids the passive loss and at-risk rules).

The new $700 billion U.S. financial bailout bill included some tax zingers to buy off House of Representative votes. One such zinger was an extension and amendment (“the Amendment”) to Internal Revenue Code (IRC) Sec. 181, which now provides a deduction for the first $15 million of the cost of certain films produced in the U.S. This article summarizes Sec. 181, including the impact of the Amendment and the Internal Revenue Service (IRS) Temporary Regulations issued last year.

In summary, Sec. 181 now permits a 100% deduction (“the Film Deduction”) for the first $15 million of the cost (“Film Costs”) of certain audio-visual works (“Qualified Audio-Visual Works”) that commence principal photography in 2008 or 2009. Section 181 originally applied to Qualified Audio-Visual Works that commenced principal photography after Oct. 22, 2004, but before the Amendment, Sec. 181 was all or nothing: if the Film Costs (including residuals and participations) exceeded $15 million, you lost ' you didn't get to deduct the first $15 million. Under the Amendment, you always get to deduct the first $15 million of Film Costs, regardless of how high the budget is. Even better, the Amendment is retroactive to Qualified Audio-Visual Works that commenced principal photography after 2007.

Section 181 applies regardless of what media the Qualified Audio-Visual Works are destined for (e.g., theatrical exhibition, television, DVD, etc.), and regardless of whether the particular expenses were incurred before or after the dates set forth above (as long as commencement of principal photography falls within those dates).

Increase in Deduction

The $15 million ceiling on the Film Deduction is increased to $20 million if the Film Costs are “significantly incurred” in certain designated low-income communities. The regulations provide that this test will be met if either: a) at least 20% of the total production costs relating to first-unit photography occur in such areas; or b) at least 50% of the total number of days of first-unit photography are shot in such areas. The preamble to the regulations states that the production costs for the first unit include the compensation paid to actors and directors, but it is not clear whether a portion of their compensation should be allocated to rehearsals or pre-production activities.

Requirements for Qualified Audio-Visual Work

There are a number of requirements in order for an audio-visual work to be a Qualified Audio-Visual Work.

• Television: For television, only the first 44 episodes of any particular series will qualify.
• U.S. Costs: Seventy-five percent of the “Total Compensation” relating to the audio-visual work paid for services performed by actors, directors, producers, writers, composers, choreographers, casting agents, camera operators, set designers, lighting technicians, make-up artists and other persons directly involved in the production of the film, whether employees or independent contractors must be paid for such services rendered in the United States (“U.S. Compensation”). There is no requirement that the individuals be U.S. citizens or residents. The definition of the United States does not include its possessions, such as Puerto Rico. For both Total Compensation and U.S. Compensation, deferments, participations and residuals are excluded.
• Content: The audio-visual work cannot include a “depiction of actual sexually explicit conduct.” Other than this one limit, there are no other limits as to content, so Sec. 181 applies to news, sports shows, reality programs, game shows and commercials. It appears that Sec. 181 would include video games, but the regulations do not expressly include them.

Costs Subject to Film Deduction

• Film Costs: The Film Deduction applies to all Film Costs, discussed above, so it is not limited to U.S. Compensation or even to production costs. For example, it would apply to the entire cost of producing Monday Night Football, including the cost of acquiring the underlying rights.
• Development and Preproduction Costs: The regulations permit the current deduction of all costs, including development and pre-production costs, relating to a film if: a) the taxpayer reasonably believes that the film will ultimately be a Qualified Audio-Visual Work; and b) the film has been set for production (referred to in the industry as “greenlit”). However, the deduction of these costs must be recaptured as ordinary income in any subsequent taxable year during which both these requirements are no longer met.
• Financing Costs: The regulations treat all costs relating to financing the film as Film Costs, including completion bond fees. This may apply to the costs of doing a tax-shelter financing transaction under Sec. 181 itself, because such costs relate to financing of the film.
• Acquisition Costs: The regulations permit all costs of acquiring a film prior to the date the film is released to qualify as Film Costs. Thus, a Sec. 181 financing transaction could shift the deduction to a new taxpayer any time prior to release of a film.
• Reformatting Costs: The regulations state that Film Costs do not include the costs of reformatting a film for release in a different media or territory after the initial release, such as costs incurred in preparation of a DVD version after the theatrical release or subsequent dubbing costs for a foreign country.

Film Deduction Limited To Owner

• Must be Owner: Only the taxpayer that owns the Qualified Audio-Visual Work for tax purposes (based on owning the benefits and burdens of the work) and pays the Film Costs can take the Film Deduction, even if the owner pays an independent production company to physically produce the work. Thus, the deduction applies to the taxpayer that is otherwise required to capitalize the Film Costs. It is not entirely clear just what the taxpayer has to “own.” It is probably not necessary to own the copyright; ownership of distribution rights should suffice because that is the real value of a film. However, the regulations state that a taxpayer that obtains only a “limited” license or right to exploit a film does not have the requisite ownership, but there is no definition of just what “limited” means.
• Subcontracting Production: There is no requirement that the owner be the actual producer of the Qualified Audio-Visual Work; the owner is entitled to the Film Deduction even if the owner pays an independent film production company to physically produce the film.

Election

The taxpayer is required to make a binding election to deduct the Film Deduction in lieu of normal income-forecast amortization with respect to each particular Qualified Audio-Visual Work. The election must be made by the due date (including extensions) of the tax return for the first tax year in which qualifying costs for such work could be deducted. As mentioned above, this is the year that: a) the taxpayer pays or incurs costs for a film that it reasonably believes will ultimately qualify under Sec. 181; and b) the film has been set for production. Any Film Costs for that film that the taxpayer has capitalized in prior years become deductible in the year the election is made. If the election is not timely made, the election is lost as to that film, so the election is “use it or lose it.” The election is made by the owner of the film (even if a pass-through entity) and by the parent of a corporate consolidated group. The election is utilized by deducting the Film Costs on the tax return and by attaching a statement to the return setting forth certain information required by the regulations.

If the film subsequently fails to qualify as a Qualified Audio-Visual Work or if the taxpayer subsequently revokes the Sec. 181 election, the taxpayer must report as ordinary income the net benefit it obtained under Sec. 181 compared to the result if that section had not applied.

Other Tax Provisions

More important than what is written in Sec. 181 is what is not written, since taxpayers must consider all the other provisions and doctrines of existing tax law, some of which are discussed below.

Alternative Minimum Tax

For individuals, as long as the production activity constitutes a trade or business, the Film Deduction will be deductible for purposes of calculating the alternative minimum tax. It thus becomes critical to determine whether the particular production activity constitutes a trade or business. Although there is substantial conflicting law on this question, it is likely that production activities alone, even prior to the receipt of income, will be treated as a trade or business, so the Film Deduction should not subject individuals to the alternative minimum tax.

For corporations, if the Film Deduction is deductible for purposes of calculating “earnings and profits,” the deduction will not subject them to the alternative minimum tax. Because there are no special rules for treatment of the Film Deduction in calculating earnings and profits, it appears that the Film Deduction is deductible for purposes of calculating earnings and profits, and thus should not trigger the alternative minimum tax for corporate taxpayers.

Passive Loss Rules

If the production activity constitutes a trade or business, as seems likely to be the case, the Film Deduction will be subject to the passive loss rules with respect to certain taxpayers, including individuals and personal service corporations. C corporations that are more than 50% owned by five or fewer individuals (“Closely Held Corporations”), and that are not personal service corporations, cannot use passive losses to shelter investment income, but can use passive losses against other income. The passive loss rules do not apply to non-Closely Held Corporations.

Individuals and personal service corporations that do not “materially participate” in the activity can only deduct passive losses, including the Film Deduction, to the extent of “passive income,” which generally is limited to income from real estate and from passive interests in businesses held by pass-through entities. Passive income also includes income from the Qualified Audio-Visual Work. If the Film Deduction is restricted under the passive loss rules, the excess carries forward and may be deducted when it is “freed up” by future passive income or upon disposition of the taxpayer's interest in the activity.

At-Risk Rules

For individuals and Closely Held Corporations, the Film Deduction will also be subject to the at-risk rules. Under the at-risk rules, the taxpayer may only take a deduction for direct investment and borrowed amounts for which the taxpayer has ultimate direct recourse liability. For example, if any portion of the Film Deduction is funded with debt, the taxpayer must have ultimate liability for that debt directly to the lender, without a right to reimbursement from any third party. Such a liability will be included in the “at-risk” amount even if the risk is ameliorated with future license payments from a creditworthy licensee.

Case Law Limitations

Tax shelters based on the Film Deduction need to comply with limitations imposed by case law, including: (a) the taxpayer may need a profit motive; and (b) the transaction must not be vulnerable to being recast based on the doctrine of substance over form in a manner that would eliminate the tax benefits.

Recapture

As originally drafted, Sec. 181 did not require “recapture” of the Film Deduction as ordinary income if the film was later sold, so it was possible for the full amount of the gain on the sale to be long-term capital gain if the film was sold after one year. However, a technical amendment eliminated this benefit and subjects the Film Deduction to recapture at ordinary income rates.

Tax Shelter Financing

Most people assumed that Sec. 181 would operate the same as similar tax provisions in foreign countries, which are usually used as part of sale-leaseback transactions to net the film production about 10% of the budget of the film. However, this benefit is created from “double dipping” on these cross-border transactions, where both sides of the transaction (each residing in a separate country) claim the right to deduct the cost of the film applying their own tax laws. The problem with Sec. 181 on this score is that any film company using it is subject to tax in the U.S., so there is no cross-border double-dipping opportunity. Thus, whatever Sec. 181 giveth on the one hand (deductions given to investors), it taketh away on the other (the deductions from the film company). The film company may raise 10% of the budget from investors under a Sec. 181 deal, only to find that it is now taxed on 100% of the gross receipts, such as pre-sales, without any offsetting deduction for production costs.

It is possible to avoid this problem with advance structuring, and we have closed a number of Sec. 181 transactions that are backed by large banks (which avoids the passive loss and at-risk rules).