Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department. Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.
Rulings Directorate
Discussion and
Position Paper On
MOTION PICTURE FILMS and VIDEOTAPES
as TAX SHELTERS
Version 29/3/93 i.
TABLE OF CONTENTS
A - STANDARD FILM TAX SHELTER ARRANGEMENT
1. COMMERCIAL ARRANGEMENTS 1
2. DESCRIPTION OF THE TAX SHELTER 2
(1) Ownership of property 2
(2) Capital cost allowance 2
(3) Reporting of income 2
(4) Realization of partnership interest 33. AREAS OF CONCERN AND THE DEPARTMENT'S POSITION 4
(1) Substance v. form 4
(2) Formal concerns 6
(a) Ownership of property 6
(b) Gaining or producing income - depreciable property 7
(c) Existence of partnership 8
(d) Reporting of income 9
(e) Agreements to buy partnership interests (put options) 13
(f) At-risk rules - in general 14
(g) Negative adjusted cost base 15
(h) Section 103 16
(i) Leverage 17
(j) Doubling-up of capital cost allowance 18
(k) Diversion of income to creditors 19
(l) Conversion of debt into partnership interest 19
(m) Cessation of partnership 204. TECHNICAL REQUIREMENTS 21
5. REFERENCES 26
6. REQUIREMENTS FOR ADVANCE RULINGS 29
7. REVENUE CANADA'S CHANGING POSITIONS 31
8. OTHER GOVERNMENTAL BODIES INVOLVED 32
ii.
B - PRODUCTION SERVICES LIMITED PARTNERSHIPS
1. COMMERCIAL ARRANGEMENTS AND DESCRIPTION OF THE 32
TAX SHELTER2. AREAS OF CONCERN AND THE DEPARTMENT'S POSITION 33
(1) Deductibility of the expenses 34
(a) Reasonable expectation of profit 34
(b) Nature of the expenses (current vs capital) 35
(c) Timing of the deduction of the expenses 35
(2) Deductibility of the interest 35
(3) Application of the General Anti-Avoidance Rule 363. REFERENCES 37
APPENDIX 38
A - STANDARD FILM TAX SHELTER ARRANGEMENT 1.COMMERCIAL ARRANGEMENTS
The usual type of arrangement involves the purchase by a limited partnership of worldwide rights to a film from a producer/vendor. The partnership contracts with a production company to produce the film. If production has started before the rights are purchased the purchase price could be paid in cash or partly in cash and partly by way of an agreement to pay the vendor of the film. To finance production, the limited partnership would borrow a substantial part of the funds required, usually from the vendor of the film or the distributor of the film. The limited partnership would grant an exclusive license to distribute and exploit the film to distributors. The distributors would arrange to exhibit and otherwise exploit the films. Revenue generated from the exhibition of the film would be paid to the distributors who would not be obligated to pay any amount to the limited partnership until they had recovered their expenses and distribution fees. The net receipts would be paid to the limited partnership which would use these funds to provide a return to the limited partners. The distributor will provide a guarantee to the limited partnership that the limited partnership will be paid a minimum amount. To provide the limited partners with a return on their investment the partners may be given the opportunity to sell their partnership interests to a company that is related to the producer/vendor. The option to sell ("the put option") is at fair market value and is exercisable before the partnership receives any money from the distributor. Alternatively, the partnership may provide the limited partners their return by distributing to the limited partners the monies received from the distributor. Following the receipt of monies sufficient to provide the appropriate return, the entitlement of the limited partners to monies may be sharply reduced.
2. DESCRIPTION OF THE TAX SHELTER
(1) Ownership of property
When the limited partnership pays for the film by paying an
amount of cash, say 10%, on acquisition of the film, and
unconditionally agrees to pay the balance over a period of
years, the limited partnership will have incurred a capital
cost equal to the total purchase price. When the limited
partnership pays the entire purchase price in cash to the
producer/vendor on the acquisition of the film, the limited
partnership will have incurred a capital cost equal to the
purchase price although part of the purchase price may have
been borrowed by the partnership from the distributor or the
producer/vendor.
(2) Capital Cost Allowance
A computation will be made of the income of the limited
partnership for the year in which the film is acquired as if
it were a separate person. If the film is a certified
feature film or a certified production the leasing rules do
not apply. If the film is a certified production acquired
after 1987 the half-year rule does not apply. Also, the
available-for-use rules do not apply to a certified
production. The capital cost allowance of the film will be
prorated if the taxation year of the limited partnership is
less than 12 months. In some circumstances described in
Regulation 1100(21), the capital cost of the certified
feature film or the certified production will effectively be
reduced. The limited partnership will have a loss that
will be allocated to limited partners who, in computing
their income, will deduct this loss from other sources of
income that they may have. The limited partnership is entitled to accelerated capital
cost in respect of certified productions acquired after
1987. The limited partnership may deduct CCA in respect of
certified productions to the extent of the lesser of the
undepreciated capital cost of the property and income from
any certified production and certified feature film.
(3) Reporting of income
The distributor will provide a revenue guarantee to the
limited partnership. The guarantee will be sufficient to
provide a satisfactory return to the limited partnership,
and therefore, the limited partners. The guarantee will not
usually be payable until a time that is after the second
year end of the limited partnership. The limited partnership will report its income on the cash
basis. Therefore, it will include in its income the amount
of the revenue guarantee but only when it is received. The
agreements between the distributor and the limited partners
will provide that any net receipts from the distribution of
the film that the distributor may have received will not be
paid before the revenue guarantee is paid. In some cases,
in order to ensure that the guarantee is valuable, the
distributor will agree to postpone its right to recoup
distribution expenses.
(4) Realization of Partnership Interest
A limited partner may have the right to sell the partnership
interest, at fair market value, to a company that is usually
related, in some manner, to the producer/vendor of the film.
The limited partner may exercise this privilege before
monies are paid under the revenue guarantee and are required
to be included in the limited partner's income. Because the
fair market value of the partnership interest will usually
equal the amount of the revenue guarantee, the amount that
would be received under the guarantee will be received as
proceeds of disposition of the partnership interest. The
capital gains deduction may be claimed in respect of the
capital gain realized. Another way in which the limited partners can realize their
investment is through the receipt of a distribution of
monies by the limited partnership. The monies received from
the distributor and included in the income of the
partnership will usually be paid to the limited partners
until they have recovered their investment. After the
limited partners have recovered their investment the
arrangement for the sharing of partnership income and cash
will change. Where the producer has loaned monies to the
partnership to finance the film, it will convert its loan
into partnership units and may be entitled to (1) all of the
income and cash until the amount of its loan has been paid
(2) a prorata share of the income and cash or (3) none of
the income (which would be included in the income of the
limited partners) and all of the cash until its loan has
been paid. In all three cases, after payout all partners
will share income and cash in proportion to their interests
in the partnership which will include the interest of the
former lender acquired on conversion of its loan. In these
types of arrangements the ACB of the limited partners'
interests will be negative after the limited partners have
received their cash. However, the limited partners will
remain as partners. Examples, in the appendix, illustrate a film tax shelter
offered by a limited partnership.
3. AREAS OF CONCERN AND THE DEPARTMENT'S POSITION
(1) Substance v. Form
Discussion
Film shelters are structured by the producers in the film
industry to obtain financing that might otherwise not be
available or might not be available at the same cost. The
shelters are "priced" to provide limited partners with a
return on their monies that will exceed the return available
on more traditional types of investments. They are not
usually devised to give the limited partners a long term
equity interest in the film. The form of most film shelters involves an acquisition of a
completed or partially completed film by a limited
partnership. However, the beneficial ownership of the film
may be reacquired directly or indirectly by the producer
when the limited partners have received a more or less
determined return. When such a reacquisition of the film
takes place, the structure is economically equivalent to an
advance of monies by the partnership to the producer who
agrees to repay the funds, with an appropriate return, out
of film revenues. Under this "substantial" view, the film
would have remained the property of the producer who in
return for the advances would have granted the partnership a
right to be paid out of revenues to be generated by the
film. This right would normally be considered a capital
property to the partnership in respect of which no deduction
would be allowed to the partnership. (The arrangement may also be characterized as an acquisition
of a licence to distribute the film by the limited
partnership. However, this characterization is not
consistent with the action of the parties. The limited
partnership in fact does not usually have any control over
the distribution of the film.) Revenue Canada argued the "substantial" view of a film
shelter in Mandel (
76 DTC 6316) and CFTO Limited (
82 DTC 6139). In Mandel it was argued that the arrangement for the
acquisition of the film was a sham since the vendor of the
film acted as though it had not disposed of anything and the
Department succeeded in its argument as to the contingent
nature of the cost of the film. In CFTO it was argued that
where CFTO had the right to be bought out at a predetermined
amount by the other partner the relationship between the two
partners was really a relationship of debtor/creditor rather
than partnership. In both cases the form of the
transactions was accepted and the Department's arguments
were rejected. In more recently conceived shelters, the limited partners
may not be bought out. They may continue to have an
interest in the profit and losses of the partnership
following the receipt in cash of their return on their
investment. They will share, in all future profits and
losses, (together with the lender who either has converted
its loan into partnership interests or has subscribed for
partnership units). The limited partners thus have a
theoretically unlimited opportunity for profit. However,
the reality is that the possibility to earn future income
will depend on the commercial success of the production and,
more importantly, on the terms of the contracts between the
limited partnership and the distributor which will usually
permit the distributor to retain most of the amounts that
would otherwise have been payable to the partnership. The traditional shelters involved the creation of leverage
by the purchase of a film for a small amount of cash and a
contingent agreement to pay the balance of the purchase
price. Recent shelters involve the creation of leverage by
the purchase of a film using money borrowed from the
producer or a related person. It could be argued that, in
substance, the partnership does not have a capital cost in
the film to the extent that it was purchased with money
borrowed from the producer. This approach succeeded in
Ensign Tankers (Leasing) Ltd v Stokes ((1992) BTC 110) where
the loan to the partnership was repayable only out of
receipts from the film. The House of Lords, in obiter
dicta, said that a loan to a limited partnership should
be repayable unconditionally before any funds are
distributed to limited partners in order that the cost of
the film would include an amount equal to the loan. These
comments are obiter but the rationale could also
apply to a loan that is repayable unconditionally or
convertible into an interest in the partnership at the
option of the lender. However, there is no guarantee that a
Canadian court would apply "single composite transaction"
analysis as in Ensign Tankers (Leasing) Ltd if tax avoidance
is involved. Department's Position
In view of the Mandel and CFTO cases and absent any tax
avoidance arrangement, the Department has generally accepted
form. In cases where the facts are similar to those in the
Ensign Tankers case, legal advice will be sought.
(2) Formal Concerns
(a) Ownership of property
Discussion
The investor must acquire ownership of property which
qualifies as Class 10(w) or 12(n). It is the
Department's position that a motion picture film or
video tape exists when principal photography is
completed. (In respect of a certified feature film or
certified production, refer to Regulations 1104(2) and
1100(21)). However, the film itself is of nominal
value. Ownership of the copyright in the film is what
is of value. Therefore, it is necessary that
ownership in the copyright as well as the original or
master negative be conveyed to the partnership in
order for the partnership to be considered to have
acquired property for the purposes of Class 10 or 12. IT-441
states that it is necessary that the investor
acquire all distribution and exhibition rights in
perpetuity, although the exercise of some of these
rights may have been licensed to third parties. Copyright includes the right to distribute and exhibit
the film. These rights may be exercised by the owner
or by others pursuant to an agreement with the owner. If the producer has entered into distribution or
exhibition contracts with third parties before the
film or tape is conveyed to the partnership, and the
contracts transfer all the incidents of ownership to
the third parties (except copyright) there is concern
that the agreement between the producer and the third
parties may constitute a transfer of the ownership of
the film. If such is the case, the investors will not
have acquired ownership of the film from the producer.
See Wardean Drilling Ltd. (
69 DTC 5194). The transfer
of the ownership in a film could occur in this way
even if the investors have acquired and retained
copyright in the film. Revenue Canada attempts to ensure that an agreement
between the producer and distributor constitutes a
mere license granted by the owner of the copyright,
the producer, to the distributor and that the term of
the license is such that the copyright, which has been
transferred to the partnership, may have value at the
expiration of such term. This exercise can be
difficult given the ability of the producer and
distributor to restrict by contract the return to the
limited partnership. Where the property acquired is an episode of a
television series, each episode is considered to
constitute a different certified production provided
that it receives a separate certification number from
the Minister of Communications. Department's Position
The Department recognises ownership as indicated.
(b) Gaining or producing income - depreciable property
Discussion
The property acquired by the partnership must be
acquired for the purpose of gaining or producing
income. If it is not acquired for this purpose it
will not be depreciable property and will be deemed
not to be included in the classes in Schedule II to
the Regulations. Revenue Canada has considered that such a purpose is
present if an outlay is made with an expectation of
profit. Although factors such as the record of the
producer and the financial arrangement relating to the
production and distribution of the film should be
taken into account in determining if there is such an
expectation, in some specific situations, Rulings
Directorate has accepted that a property was acquired
for the purpose of gaining or producing income where
there was only a possibility of profit. This
concession was given in a few situations where it was
likely, but not certain, that the profit of a limited
partnership would not be a profit before taxes but a
profit that would have resulted from tax deductions,
colloquially known as an "underwater arrangement". Department's Position
In view of recent case law favourable rulings will not
be given where there is a probability that the
partnership will not make an economic profit but will
be reliant on tax deductions. (c) Existence of the partnership
Discussion
A partnership is a relationship between two or more
persons entered into for the purpose of carrying on
business, in common, with a view to profit. Can a
partnership exist if the partnership is dissolved
within a short period of time after its coming into
existence? If the partnership may cease to exist
before any income is earned and the cessation is
preordained, a ruling should not be given that the
arrangement is a partnership. Department's Position
This is a question of fact. The foregoing factors
will be taken into consideration when making a
determination. (d) Reporting of income
Discussion
Revenue guarantees are entered into between the
limited partnership and the distributor. The
guarantee will provide that a minimum amount of
revenue will be paid to the partnership by a certain
date, whether or not any revenue has been received by
the distributor. The right of the partnership to
receive the funds on that date is unconditional. In
cases where the producer made an agreement with the
distributor before transferring the film to the
limited partnership, revenues from the exploitation of
the film may already have been received by the
distributor when the limited partnership acquired the
film. In those cases the distribution agreement may
provide that some or all of the revenues from the
exploitation of the film will not be paid by the
distributor to the partnership until the date that the
revenue guarantee is payable. The partnership will report its income on the cash
basis. This permits the limited partners to sell their
partnership interests before the cash is received and
the amount received is required to be included in
computing the partnership income. The sale of the
partnership interests will be at fair market value
which will be approximately the same as the amount of
the revenue guarantee. As a result when they sell
their partnership interests, the limited partners will
realize a capital gain equal to the amount that they
would otherwise have been required to include in
income if they had remained as partners. For rulings purposes, the Department has a
longstanding position to allow the partnership to
report in its income only the amounts received in the
year. The reason for allowing film partnerships to
report on the cash basis is that, according to
industry representatives, such a basis is common in
the industry. Support for reporting on the cash basis is found in
Boosey and Hawkes ( Canada ) Limited (
84 DTC 1728), a
Tax Court decision. The taxpayer corporation was in
the music publishing business and had reported its
royalty income on a cash basis consistently for some
twenty years without objection by the Department. The
court found that even if the royalty income was
receivable, the taxpayer was entitled to use the cash
method of reporting his income since that method was,
from an accounting point of view, proper, necessary
and common to the music industry. There was no
evidence to suggest that the method was either
commercially inappropriate or failed to accurately
disclose the taxpayer's true income.
Financial Accounting Standards Board Statement #53
"Financial Reporting by Producers and Distributors of
Motion Picture Film" gives the following guidelines
for licensors of television program material: "A licensor shall recognize revenue from a
license agreement for television program
material when the license period begins and all
of the following conditions have been met:
(a) The license fee for each film is known. (b) The cost of each film is known or
reasonably determinable. (c) Collectibility of the full license fee is
reasonably assured. (d) The film has been accepted by the licensee
in accordance with the conditions of the
license agreement. (e) The film is available for its first
showing or telecast. The Act requires the use of the cash method of
accounting with respect to several types of income
(none of which is relevant here). It permits the cash
method for computing income from a fishing or farming
business. Otherwise, the Act is silent with respect
to the computation of income from a business or
property. Section 9 states that a taxpayer's income
from a business or property is the profit for the
year. The Courts have held that the cash method may
be used if it truly reflects the income position of
the taxpayer. On the other hand, Revenue Canada has
stated in paragraph 5 of
IT-261R
that as a general
rule taxpayers must use the accrual method of
accounting to calculate income from a business or
property unless the Act provides otherwise. In West Kootenay Power and Light Company (
92 DTC 6023)
the Federal Court of Appeal held that the principle of
recognition of income to be applied is the principle
that gives the "truer picture." A partnership that reported its income on the accrual
basis would include in income those amounts to which
it has a legal, though not necessarily immediate
right, to receive. This might include amounts held by
a distributor in excess of what the latter was
permitted to deduct in respect of its expenses of
distribution, even though those amounts were not
payable until a future time. Similarly, a partnership
that reported its income on the accrual basis would be
required to include in income the amount of a revenue
guarantee of the type described above. If the amount
of the revenue guarantee is ascertainable, is
unconditionally payable and is secured, it seems
reasonable that this amount should be viewed as being
receivable by the partnership. The inclusion of both
of these amounts would seem to be consistent with GAAP
in that reporting these amounts on the accrual basis
would more accurately reflect the income of the
partnership than reporting them on the cash basis. Revenue Canada has taken the position in one case that
the non-recognition of income represented by cash
received by the distributor but not payable to the
limited partnership until a future date is
objectionable. Subsection 245(2) of the Act was
considered applicable to require an inclusion in
income of the cash held by a distributor. However, in
that case factors other than the deferral of
recognition of income were also considered material in
reaching the decision. It is difficult to determine if and when an amount
should be included in the income of the partnership
since the recognition of income depends on the
contractual arrangements between the parties, which
would be structured in such a way as to unduly defer
the time that the income is earned. The cases that
were considered offensive involved egregious hold-
backs of funds where it was obvious from the
circumstances that the payment of the funds held by
the distributor was virtually assured. Other
arrangements will be less blatant. The funds may not
be paid to the distributor by its sub-distributors or
the release of the funds by the distributor to the
partnership may be SUBJECT to conditions that are more
or less substantial. In these cases, an attempt to
include income on an accrual basis would be a
difficult exercise. For example, when the partnership acquires a
television series, the arrangements call for the
network to pay advances to the distributor who will
include them in income only when the last episode has
been delivered. The argument for delaying the
recognition of income is that the advances would be,
under the terms of the contracts, recoupable by the
network in the event that all the episodes of the
series are not delivered. This is said to be
consistent with the American accounting guideline
mentioned above, which states that a licensor has to
recognize revenue from a licence agreement for
television program material only when the
collectibility of the full license fee is reasonably
assured. If the contract provides that the
distributor is not entitled to the monies until the
delivery of the last episode, it would be difficult
for Rulings Directorate to maintain that the advances
to the distributor should be included in income of the
partnership when received by the distributor.
On the other hand, if the money received by the
distributor from the network has the quality of
income, it will not be considered acceptable that the
money is dammed at the distributor level and the
partnership defers taxation until the delivery of the
last episode or the payment of the revenue guarantee. Department's Position
Rulings Directorate will continue to accept the cash
basis only if it truly reflects the income position of
the taxpayer and provided that the flow of cash from
the viewers through the distributor(s) and sub-
distributor(s) or others to the limited partnership is
not artificially dammed. In the case of a TV series,
timing of the inclusion in income of the limited
partnership of amounts received by the distributor
will depend upon the agreements between the parties
and the weight or relevance that a court would give to
any conditions included in those agreements (for
example, Foothills Pipelines (Yukon) Ltd (
90 DTC 6607)). (e) Agreements to buy partnership interests (put options)
Discussion
The use of put options to dispose of limited
partnership units converts what would otherwise be
received as income from the exploitation of the film
to a capital gain on the sale of the units. The
income that is not recognized by the limited partners
would be recognized as income of the purchaser of the
interests who is normally related to the
producer/vendor of the film. Revenue Canada has accepted puts, in principle, in the
tax shelter context for at least 12 years on the basis
that puts gave the limited partner liquidity that it
otherwise would not have had because the property
owned by the partnership did not earn income. Some arrangements involve the sale by limited
partners of their units to a non-resident purchaser
before the revenue guarantee becomes payable. Others
involve the acquisition of, or subscription for,
partnership units by a non-resident after payment of
the revenue guarantee to the limited partners. This
acquisition of or subscription for partnership
interests will dilute substantially the participation
of the limited partners in the income of the
partnership. As a result the income from the
exploitation of the film which was produced in Canada
will be received by partners who were not partners
when the film was produced and who are not resident in
Canada. The result is that partnership income (which
usually is from foreign sources) will not be taxable
in Canada. Rulings Directorate would normally be prepared to rule
favourably in a situation where the put is exercisable
or the non-resident subscribes for partnership
interests after the limited partners have recognized
income at least equal to the amount of the revenue
guarantee or where there had been a clear expectation
that the partners would recognize income before the
put was exercisable. Where a put is exerciseable before income will be
receivable by the partnership the arrangement would
have to be examined to determine whether the revenue
flow to the partnership will be artificially dammed.
Where this is not so but the revenue guarantee is the
only source of income up to the time it is payable and
after the put is exerciseable, it may be arguable that
the amount of the revenue guarantee should be accrued
during the period before it is payable. Department' Position
Put options are accepted provided they are not used in
an arrangement the principal purpose of which is to
convert income to capital gains. (f) At-risk rules - in general
Discussion
A limited partner in a limited partnership which owns
a film, is subject to the application of the at-risk
rules. Accordingly, the limited partner has to
compute his at-risk amount, which will limit the
amount that he may claim in respect of his share of
the partnership's loss. A prescribed revenue
guarantee (basically defined in Regulation 7500 as a
revenue guarantee in respect of a prescribed film
production provided by a licensed broadcaster or
bona fide film distributor and certified as
such by the Minister of Communications) does not
reduce the at-risk amount. Also, a put option given
to a limited partner will not reduce the at-risk
amount as long as the amount of the put does not
exceed the fair market value of the unit of the
partnership at the time of the disposition. Rulings
Directorate has held that a letter of credit given by
a financial institution to guarantee the payment of
the prescribed revenue guarantee or the payment of the
put will not reduce the at-risk amount. Department's Position
It is Rulings Directorate's position that a letter of
credit given by a financial institution to guarantee
the payment of the prescribed revenue guarantee will
not reduce the at-risk amount. (g) Negative adjusted cost base
Discussion
An example of the manner in which the negative ACB
arises is found in the Appendix. The negative ACB of the limited partner's partnership
interest arises because of the allocation to the
limited partner of the loss of the partnership (that
results from the claim of capital cost allowance in
respect of the capital cost attributable to the monies
loaned to the partnership by the producer) and the
payment of cash to the limited partner.
However, this is permitted by the Act. The limited
partner can receive funds, free of immediate tax
consequences, the proceeds of which were used to
produce the film and are included in the capital cost
of the film. It is clear that the at-risk rules do
not require that monies received by the limited
partnership be used to pay creditors of the
partnership before the monies are distributed to
limited partners. Rulings Directorate has been concerned with these
arrangements although the negative ACB will give rise
to a gain that is subject to tax when the limited
partner disposes of his partnership interest.
However, there is no prohibition in the Act against
the distribution to the limited partner in these
circumstances. Department's Position
A negative ACB is permitted by the Act. This, in and
by itself, is acceptable provided that the partnership
is not artificially kept alive in order to prevent
crystallisation of the negative ACB into a capital
gain, for example, before the death of the partner or
provided negative ACB has not resulted from a
disguised sale of a partnership interest as in
Richard K. G. Stursberg (
91 DTC 5607). (h) Section 103
Discussion
Does section 103 of the Act apply to the partnership
profit/loss sharing arrangement? Given that the
purpose of tax shelters is to allow the limited
partners to deduct losses in respect of the cost of a
film that is referrable to the contribution of the
producer, thereby reducing the amount of cash that has
to be laid out by the producer to provide a return on
the monies advanced by the limited partners, it seems
clear that the principal reason for the sharing
agreement is to reduce or postpone the tax of the
limited partners. Revenue Canada could argue that it
is not reasonable to allocate to the limited partners
the losses referrable to the partnership property for
the payout period, and in effect, treat the limited
partners as owners of the property in that period,
when they cease to have any substantial equity
interest in the property after payout. This argument
would be more persuasive if the sharing of income and
losses was changed after payout to provide that the
limited partners were entitled to only, say, a 1%
interest in the profits and losses of the partnership.
However, the more sophisticated agreements provide
that the limited partners will share prorata following
the payout of the creditor/partner. To date, Revenue Canada has not impugned the
reasonable allocation of profits and losses during
payout and has rarely applied section 103 of the Act
to film limited partnerships. In one case, Revenue
Canada sought to apply section 103 in circumstances
involving a loss sharing arrangement in which a
limited partner was to be paid out through the tax
system before any revenue was generated. Department's Position
Section 103 will be applied as appropriate.
(i) Leverage
Discussion
A taxpayer has incurred a capital cost in a certified
production equal to the purchase price of the film or
tape. Where the purchase price is not payable for
some years, the capital cost is equal thereto provided
it is unconditionally payable. This is recognized in
paragraph (d) of the definition of "certified
production" in Regulation 1104(2), which provides that
a person who acquires a certified production must pay
in cash at least 5% of the capital cost of the film at
the end of the year. In other words, 95% of the
purchase price may be unpaid. However, a film or tape does not qualify as a
certified production where the taxpayer has issued in
payment or part payment for its acquisition a bond,
debenture, bill, note, mortgage, hypothec or similar
obligation in respect of which an amount is not due
until a time that is more than four years after the
end of the taxation year in which the taxpayer
acquired the film or tape. A taxpayer who borrows money to purchase a film has a
cost of a certified production equal to the purchase
price, provided the borrowing is pursuant to a bona
fide loan. The capital cost of a film will be
reduced by the amount of certain types of revenue
guarantees given in respect of the film. A revenue
guarantee that is certified by the Minister of
Communications to be a guarantee under which the
person who agrees to provide the revenue is a licensed
broadcaster or bona fide film or tape
distributor will not reduce the capital cost of a
film. A letter of credit, issued by a financial
institution to guarantee the payment of the revenue
guarantee, has been considered not reduce the capital
cost of the film. When the taxpayer borrows money from a person not
dealing at arm's length with the vendor in order to
purchase the film or tape and the amount is due more
than 4 years after the year of acquisition, such an
arrangement avoids the restrictions mentioned above.
These situations will be dealt with on a case by case
basis. Department's Position
Leverage is permitted by the Act with respect to the
purchase price of a film, but in an obiter
comment in the recent UK case of Ensign Tankers
(Leasing) Ltd. v. Stokes ((1992) BTC 110 (H.L.)), one
member of the Court indicated that on the facts of
that case the loan should have been repaid before any
payments were made to the partners, if the partners
were to be permitted to claim an investment for tax
purposes in excess of the $3,250,000 amount they truly
incurred. It should be noted that the funds allegedly
"lent" to the partnership in that case, went back to
the "lender" the very same day funds were advanced.
In cases where the facts are similar legal advice will
be sought. (j) Doubling-up of capital cost allowance
Discussion
This arrangement is structured to circumvent the
recent reduction (to 30%) of the rate of CCA that may
be claimed in respect of films. It will usually be as
follows: Partnership B acquires all but one of the
interests in Partnership A, on the day Partnership A's
fiscal year ends (2 days before Partnership B's fiscal
year-end), with the sole purpose of becoming, on the
following day, the owner of a 99.9% undivided interest
in a film once Partnership A is dissolved pursuant to
subsection 98(3). Thus, in computing its income for
its fiscal year ending two days later, Partnership B
deducts the maximum CCA for the film, even though
Partnership A has already claimed the CCA for the
film. Subsection 245(2) was considered to apply to prevent
Partnership B from deducting the maximum CCA for the
film following the dissolution of Partnership A. Department's Position
Subsection 245(2) will be applied in circumstances
where an arrangement is structured to circumvent the
CCA limitations in the Regulations. (k) Diversion of income to creditors
Discussion
All income arising from the exploitation of the film
would normally be income of the partnership received
under the terms of the agreement between the
partnership and the distributor. Some tax shelters could be structured to provide that
the distributor would pay creditors of the partnership
or of the investors before income is paid to the
limited partnership. Such amounts would nevertheless
be income of the partnership. Department's Position
All income arising from the exploitation of a film is
normally income of the partnership and must be shown
as such. (l) Conversion of debt into partnership interest
Discussion
When the creditor exercises its right to convert its
loan into a partnership interest, section 51 of the
Act does not apply to that conversion. Accordingly,
if the partnership interest has a fair market value
that is greater than the amount owing, the creditor
will have a gain. If the fair market value of the
partnership interest is less than the amount owing,
the creditor will have a loss. In arrangements in which the creditor is entitled to
all the income and losses following conversion of the
loan, it is arguable that the limited partner has
partly disposed of his partnership interest because
his entitlement to share in profits and losses has
been reduced to nil. Although the issue is certainly
arguable, the proceeds of disposition of the interest
would be equal to the amount of the liability
converted. This argument relies on the Stursberg
decision. In that case, the entitlement to profits
and losses of the partner who disposed of his interest
was reduced. If the limited partner retains rights to partnership
capital, it may be difficult to argue that he has
disposed of his partnership interest. Department's Position
The Department's position is as described above.
(m) Cessation of partnership
Discussion
There would be a disposition of the partnership
interest by the limited partner when the partnership
ceases to carry on business. If this happened, the
partnership would be considered to be wound up and the
limited partner would receive proceeds of disposition.
This disposition would occur when the partnership
ceased to carry on business even though it may
continue to be registered under a partnership act. Department's Position
The Department's position is as described above.
4. TECHNICAL REQUIREMENTS
DEFINITIONS
"Certified feature film" and "certified production" are defined in subsection 1104(2) of the Regulations. The requirements for certification by the Minister of Communications are outlined in paragraphs (a) and (b) in respect of each type of production. Where a certificate has been issued in respect of a film or tape by the Minister of Communications, an investor's interest in a film or tape may not qualify as a certified production if it is acquired in the manner described in (c) of the definition of certified feature film or in (c), (d), (e) or (f) of the definition of certified production or, in either case, if the certification has been revoked by the Minister of Communications. These requirements are discussed in item 6—Requirements for Advance Rulings.
"Revenue guarantee" is defined in paragraph 1104(10)(c.1) as a contract or other arrangement under the terms of which an investor has a right to receive a minimum rental revenue or other fixed revenue in respect of a right to the use in any manner whatever, of a certified feature film or certified production.
"Prescribed revenue guarantee" is defined in Regulation 7500 as a revenue guarantee in respect of a prescribed film production, which guarantee is certified by the Minister of Communications to be a guarantee under which the person who agrees to provide the revenue is a licensed broadcaster or bona fide film or tape distributor. It is relevant for the purposes of subparagraph 96(2.2)(d)(ii) of the Act.
"Principal photography" is not defined in the Act or Regulations. It refers to the actual shooting of the film with the presence of the principal artists and technical personnel.
"Prescribed film production" is defined in Regulation 7500 as a certified production defined in subsection 1104(2).
LEASING PROPERTY AND PRORATION OF CCA
A partnership that acquires a certified feature film or certified production may, following the assumptions in subsection 96(1) of the Act, deduct capital cost allowance to the maximum amount permitted. The leasing property rules do not apply to a property in Class 10(w) or 12(n). The loss of the partnership will be allocated to the limited partners who may deduct the loss from other income. If the film or production is not included in Class 10(w) or 12(n) then the property will be a leasing property.
Where the film is a property of a partnership and the fiscal period of the partnership is less than 12 months, then the deduction for capital cost allowance is required to be prorated.
FEATURES AND REQUIREMENTS OF CERTIFIED PRODUCTION
(1) Requirements for Certified Productions
In addition to the conditions that must be met to obtain
certification of the film or tape by the Minister of
Communications the following conditions must also be
complied with: (a) the investor must acquire his interest on or before
the day that is the earlier of (i) the day of the first commercial use of the film
and (ii) 12 months after the completion of principal
photography, (Paragraph (c) of the definition of a "certified
production" in Regulation 1104(2))
(The comments in paragraph 9 of
IT-441
re first
commercial use should be noted), (b) the investor/partnership must pay in cash as of the
end of the year at least 5% of the capital cost of the
film (paragraph (d) of the definition of a "certified
production" in Regulation 1104(2)), (c) the balance of the capital cost must be paid for by
the issuance of a note or similar obligation all
amounts in respect of which are due before the end of
the fourth taxation year after the taxation year in
which the investor/partnership acquires his interest
in the film (paragraph (e) of the definition of a
"certified production" in Regulation 1104(2)), (d) the investor/partnership must not acquire his interest
from a non-resident (paragraph (f) of the definition
of a "certified production" in Regulation 1104(2)), or (e) the certificate cannot have been revoked by the
Minister of Communications as a result of an incorrect
statement made in furnishing the information for
purposes of obtaining certification (paragraph (g) of
the definition of a "certified production" in
Regulation 1104(2)).
(2) When may capital cost allowance be deducted
(a) Principal photography of the certified feature film or
certified production must be completed by the end of
the taxation year and the investor/partnership must
own a unit at that time in order to claim full CCA for
that year (Refer to paragraph 14(a) of
IT-441
). (b) Where principal photography is completed within
60 days after the end of the year, subparagraphs
1100(21)(a)(i) and (ii) of the Regulations reduce the
capital cost of the film or production by the
difference between the cost of the film to the
investor/partnership at the end of the year and the
taxpayer's proportionate share of the production costs
incurred in respect of the film before the end of the
year. (Refer to paragraph 14(b) of
IT-441
). (c) Where principal photography is not completed within 60
days after the end of the year, subparagraphs
1100(21)(a)(i) and (iii) of the Regulations reduce the
capital cost to the extent of the excess of the cost
of the film to the investor/partnership as at the end
of the year over the lesser of the taxpayer's
proportionate share of the production costs incurred
before the end of the year and the proportion of the
production costs incurred to the date the principal
photography is completed that the percentage of the
principal photography completed as of the end of the
year, as certified by the Minister of Communications,
is of 100%. (d) If the film or tape produced does not qualify as a
class 10(w) or 12(n) asset, the film or tape will be a
class 10(s) asset. Where the film is a class 10(s)
asset, the investor/partnership is SUBJECT to the
"leasing property" rules in the Regulations and
available for use rules and CCA may be claimed at a
rate of 30% per annum on a declining balance basis but
not to exceed the net income (before CCA) to the
investor/partnership from this investment and such
other "leasing properties" owned by him.
(3) Revenue Guarantees A revenue guarantee is defined in paragraph 1104(10)(c.1) of
the Regulations as an arrangement giving a taxpayer a right
to receive a minimum rental for the use of his film.
Paragraphs 1100(21)(b), (c) and (d) of the Regulations are
intended to reduce the capital cost, and therefore the
amount of CCA that may be deducted, by the amount of certain
revenue guarantees that have not been included in computing
the taxpayer's income. If the capital cost, otherwise
determined, has been reduced because of the existence of a
revenue guarantee, the cost will be increased by the amount
of income received by virtue of the guarantee. Some revenue guarantees do not reduce the capital cost of
the film or production. These are guarantees certified by
the Minister of Communications in the circumstances
described in paragraphs 1100(21)(b) and (c) and which are
due within 4 years after the guarantor has the right to use
the film or tape, as described in paragraph 1100(21)(d). Paragraph 1100(21)(b) relates to revenue guarantees entered
into before the later of the date that principal photography
of the film or tape is completed and the date the investor
acquired the film or tape. When there is such a revenue
guarantee, its terms and conditions must be examined to
determine, having regard to the conditions that must be
satisfied, whether or not "it may be reasonably be
considered certain, having regard to all the circumstances,
that the investor will receive revenue ...". Paragraph 19
of
IT-441
states that the contractual conditions that must
be satisfied before revenue is payable must be substantive
and not merely window dressing in order to avoid a reduction
in the capital cost of the film pursuant to paragraph
1100(21)(b). Paragraph 1100(21)(c) relates to a revenue guarantee given
by a guarantor not dealing at arm's length with the vendor
of the film or with the investor, or one under which the
vendor or a person not dealing at arm's length with the
vendor undertakes to fulfil the guarantor's obligations. Paragraph 1100(21)(d) covers revenue guarantees not dealt
with under preceding paragraphs. It relates to a revenue
guarantee under which an amount is not due until more than
four years after the first day on which the guarantor has
the right to use the film. A partnership may acquire the benefit of a revenue guarantee
when it acquires a film or production from a vendor/producer
who had already contracted with a distributor, or if a
previous agreement had not been reached, when it contracts
with a distributor for the exploitation of the film. If the
property acquired is a certified production and the
guarantor is certified by the Minister of Communications to
be a licensed broadcaster or bona fide film or tape
distributor, then the capital cost otherwise determined of
the certified production to the partnership will not be
reduced. The benefit of this revenue guarantee is also relevant in
determining the amount of the partnership loss that may be
deducted by a limited partner. It is intended to reduce the
impact of any loss that a limited partner may suffer by
reason of being a member of the partnership or of his
holding or disposing of his partnership interest and is
described in paragraph 96(2.2)(d) of the Act. However,
because the revenue guarantee is a prescribed revenue
guarantee, it will not reduce the at-risk amount of a
limited partner. The same result follows even if the guarantor does not deal
at arm's length with vendor/producer provided that the
Minister of Communications certifies that the guarantor is a
licensed broadcaster or bona fide film or tape
distributor and the cost of the film or tape does not
include any amount in respect of the guarantee.
5. REFERENCES
A. Income Tax Act and Regulations
Section 237.1: Tax Shelters defined
Section 96(2.1), (2.2), (2.3) to (2.7): Limited Partnership
losses and at-risk amount.
Paragraph 13(26): Available for use rules do not apply
Paragraph 20(1)(a): Deduction for CCA
Regulation 1100(1)(a): CCA rates
Regulation 1100(2): Half-year rule does not apply
Regulation 1100(1)(l): Additional allowances
Regulation 1100(3): Taxation year less than 12 months
Regulation 1100(17)(c): Certified production not "leasing
properties"
Regulation 1100(21)(a): Reductions in CCA as a result of
"principal photography" not being completed in the year
the investor acquires his property.
Regulation 1100(21)(b) to (d): Revenue guarantees
Regulation 1101(5h): Separate class
Regulation 1104(2): Definitions of "certified feature film"
and "certified productions"
Regulation 1104(10)(b): Revocation of certificate by
Minister of Communications
Regulation 1104(10)(c.1): Definition of revenue guarantee
Paragraph (s) and (w) of Class 10, Schedule II
Paragraph (n) of Class 12, Schedule II
Regulation 7500 B. Interpretation Bulletins
IT-441 : CCA—Certified Production
IT-164R : Leveraged Investments
IT-283R2
: Capital Cost Allowance- Video Tapes, Videotape
Cassettes, Films, Computer Software and Master Recording
Media C. Court Cases
Boosey and Hawkes (Canada) Limited v. M.N.R.,
84 DTC 1728 (TCC)
C. Ralph Lipper v. The Queen,
80 DTC 6248
(FCTD)
The Queen v. CFTO TV Limited,
82 DTC 6139
(FCTD)
Crown Cork & Seal Canada Inc. v. The Queen,
90 DTC 6586 (FCTD)
Ensign Tankers (Leasing) Ltd. v. Stokes, 1991
BTC 136 (U.K.)
The Queen v. Gelber,
83 DTC 5385 (FCA)
Mandel v. The Queen,
80 DTC 6148 (SCC)
McKee v. The Queen,
77 DTC 5345 (FCTD)
Reed v. Young, (1986) STC 285 (U.K.)
Signum Communications Inc. v. The Queen,
88 DTC 6427 (FCTD), affirmed by
91 DTC 5360 (FCA)
Moloney v. The Queen,
92 DTC 6570 (FCA)
H. Simon, CA-3,
87-2 USTC (U.S.)
Joel Hagler, 86 TC 598 (No. 38) (U.S.) D. Publications
Richard M. Wise, "Motion Picture Films as a Tax Shelter"
in Report of Proceeding of the Twenty-eight Tax
Conference, 1976 Conference Report (Toronto: Canadian
Tax Foundation), 1977, at 205. Richard M. Wise, "A Cineramic View of Motion Picture Film
Investments", (1976), vol. 24, no. 2, Canadian Tax
Journal, (Toronto : Canadian Tax Foundation), at 157. Richard M. Wise, "Motion Pictures as a Tax Shelter", CA
Magazine, October 1977, at 36. Richard M. Wise, "Evaluating Motion Picture Film
Investments", in Report of Proceeding of the Thirtieth
Tax Conference, 1978 Conference Report (Toronto:
Canadian Tax Foundation), 1979, at 666. Richard M. Wise, "The New Rules For Motion Picture Tax
Shelters", (1979), vol. 27, no. 3, Canadian Tax
Journal, (Toronto: Canadian Tax Foundation), at 245. Peter E. McQuillan, Investing in Canadian Films:
Evaluating The Risks and The Rewards, Don Mills, Ont.:
CCH Cnadaian Limited, 1980, 79 p. Richard M. Wise, "Ought You to be in Pictures?", CA
Magazine December 1981, at 22. Garth H. Drabinsky, "Feature Film Production in Canada and
the Newly Proposed Tax Shelter Regulations: Enlightenment or
Tunnel Vision?, in Report of Proceeding of the Thirty-
third Tax Conference, 1981 Conference Report (Toronto:
Canadian Tax Foundation), 1982, at 310. Peter E. McQuillan, "Recent Developments in Certified
Feature Production and in Ontario Small Business Development
Corporations" in Report of Proceeding of the Thirty-fifth
Tax Conference, 1983 Conference Report (Toronto:
Canadian Tax Foundation), 1984, at 177. Sydney Sweibel, "Tax Shelters: Present and Future", in
Report of Proceeding of the Thirty-Seventh Tax
Conference, 1985 Conference Report (Toronto: Canadian
Tax Foundation), 1986, at 47:1. Paul Jutras, "Les abris fiscaux", Congrès 85,
Association Québécoise de Planification Fiscale et
Successorale, 1986, at 305. Normand Bacal and Richard Lewin, "Once Bitten, Twice Shy?
The Canadian Film Industry Revisited", in Report of
Proceeding of the Thirty-Eighth Tax Conference, 1986
Conference Report (Toronto: Canadian Tax Foundation), 1987,
at 46:1. Michel Prince, "Abris fiscaux", Congrès 86,
Association Québécoise de Planification Fiscale et
Successorale, 1987, at 39. Jeffrey Mandel, "Recent Developments in Tax Shelters", in
Report of Proceeding of the Thirty-Ninth Tax Conference,
1987 Conference Report (Toronto: Canadian Tax Foundation),
1988, at 45:1. Steven A. Yaphe, "Tax Shelters After Tax Reform", in
Report of Proceeding of the Fortieth Tax Conference,
1988 Conference Report (Toronto: Canadian Tax Foundation),
1989, at 29:1. Jean Théberge, "Abris fiscaux /Films, actions accréditives,
RÉA, SPEQ, R & D", Congrès 88, Association de
Planification Fiscale et Financière, 1989, at 729. Norman Bacal, "Not Just Another Sequel: The Canadian Motion
Picture Industry After Tax Reform", (1988), vol. 36, no. 3,
Canadian Tax Journal, (Toronto: Canadian Tax
Foundation), at 547. Louise Houle, "Financement du film au Québec: Mise à jour",
(1989), Vol. 11, no. 1, Revue de planfication fiscale et
successorale, Association de Planification Fiscale et
Financière, at 61. Michel Matifat, "Abris fiscaux-1989", Congrès 89,
Association de Planification Fiscale et Financière, 1990, at
211. Jeffrey Mandel, "Tax Shelters in the 1990s", in Report of
Proceeding of the Forty-Third Tax Conference, 1991
Conference Report (Toronto: Canadian Tax Foundation), 1992,
at 35:1.
6. REQUIREMENTS FOR ADVANCE RULINGS
A. General
Paragraph (a) and (b) of the definitions of a "certified
feature film" and a "certified production" in subsection
1104(2) of the Regulations refer to the matters which are
certified by the Minister of Communications. However, the
following facts are usually set out in connection with
requests for advance rulings: (i) the name of the producer, who must be a Canadian;
(ii) the names of any corporations set up by the producer
to produce the film, whether or not they are Canadian,
and the names and nationalities of the shareholders
and directors; (iii) the involvement of non-Canadians and their explicit
role. If, after reviewing the details in respect of the production
of the film, it is felt that it will not qualify for
certification this matter should be discussed with the Film
Certification Office of the Department of Communications
(with taxpayers'permission—see
IT-441
paragraph 26(b)).
Rulings should not be given if the Department of
Communications advises that the film will not be certified. B. Ownership
As in the case of any depreciable property on which CCA may
be claimed under paragraph 20(1)(a), an investor in a film
must acquire "ownership" thereof. In this regard, the
aspects of ownership with which we are always concerned are
specified in paragraphs 2 to 6 of
IT-441
. For advance
rulings, the facts must reflect, or we must be otherwise
satisfied that: (i) an investor will beneficially own an undivided
proprietary interest either alone, or jointly with
other persons in all components of the film (as
specified in paragraph 2 of
IT-441
) and not merely an
interest in some elements thereof (in the case of a
series of certified productions, ownership in each
episode of the series from which he is entitled to
income, is required); (ii) the appointment of a sales agent to exploit the film
does not result in the investor giving up real and
effective control of the property (paragraph 3 ofIT-441
). The requirement to require a reasonable
standard of performance and the conditions to permit
an agent's removal will be considered by reference to
the relevant agreement(s). For the majority of the
cases, the investors have the right to replace an
agent by way of a 2/3's majority vote of the arm's
length investors. Other standards of performance may
also be covered in an agreement between the agent and
investors. As well, the agent's fee must be
reasonable (probably a percentage of gross) and not
for a fixed sum which might represent the exploitable
value of the film; (iii) the appointment of a licensee does not result in the
owner-investor disposing of his ownership interest.
As in the case of the appointment of a sales agent, we
must ensure that an investor has not given up real and
effective control of his interest in the film. The
basis of the licensing fee must be reasonable and not
be for a fixed sum or a guaranteed minimum which may
be representative of its fair market value (as
contemplated in paragraph 4 of
IT-441
); C. Certification
Paragraph 1104(2)(a) and (b) of the Regulations
Under paragraph (w) of class 10 and paragraph (n) of class
12, the film must be certified and the requirements for
certification are set out in subsection 1104(2) of the
Regulations. As noted earlier, the Minister of
Communications certifies as to whether or not the
requirements of paragraphs (a) and (b) in the definition of
"certified productions" are met. In this regard, the facts
set forth in any request for an advance ruling should
indicate that the Producer has received indications from the
Minister of Communications that, based on the information
submitted to him, the film will be certified. In addition
to this we insert a proviso preceding the rulings given that
the film will be certified and a condition that the rulings
are binding provided that the certification is not
subsequently revoked, to ensure that it is clear that at all
relevant times the rulings are only binding provided that
the film is certified.
D. Budget In connection with a ruling request, the Budget for the film
will be reviewed. Unusual items such as deferred charges
should be considered as a possible way of circumventing the
95% debt limit. Where interim financing has been obtained by
the producer in order to complete pre-production, the
proceeds from the sale of film units usually repay such
loans.
7. REVENUE CANADA'S CHANGING POSITIONS
Although there was no support in the legislation, our position was that a film was considered to have come into existence and become a depreciable asset once principal photography was completed. Thus, unlike a building where CCA could have been claimed on work- in-progress, a motion picture could only be depreciated when a depreciable asset actually existed in a completed form.
As a result of a request from the Assistant under Secretary of State for Cultural Affairs in 1976, our position was modified to permit a taxpayer to write off a percentage of the costs incurred to the point of completion of principal photography, in the year preceding the one in which the principal photography was completed. This position was "written into" the Regulations in December 1978.
8. OTHER GOVERNMENTAL BODIES INVOLVED Communications Canada Canadian Audio Visual Certification Office Room 600 300 Slater Street Ottawa, Ontario R. Soucy, Manager Anne-Marie Turcotte Jeff Haire
Telephone: 990-4092
Under subsection 1104(2), the Minister of Communications must certify a film or tape as a "certified production" or as a "certified feature film" in order for the film or tape to qualify as property under paragraph (w) of Class 10 or paragraph (n) of Class 12.
B - PRODUCTION SERVICES LIMITED PARTNERSHIPS
1. COMMERCIAL ARRANGEMENTS AND DESCRIPTION OF THE TAX SHELTER
Another type of film tax shelter in respect of which the Rulings Directorate has been asked to rule involves a two tier limited partnership structure. The following summarizes the facts and proposed transactions dealt with in a typical case.
A partnership ("Partnership A") will issue limited partnership interests to investors (the "investors") and will use 80 % of the proceeds to invest in another limited partnership ("Partnership B") and 20 % to pay its own expenses. Partnership B will sign a production services agreement (the "Production Services Agreement") with a producer based in, say, the United States (the "U.S. producer") by virtue of which Partnership B will undertake to provide to the U.S. producer, at its own expense, the technical knowledge, expertise and financing (the "Services") necessary for the U.S. producer to produce part or all of a film or television series (the "Picture") in Canada.
The Services will be rendered by Partnership B in exchange for fees to be paid by the U.S. producer calculated by reference to the gross receipts earned by the U.S. producer from the exploitation of the Picture.
The Services will include the services of all personnel and the provision of appropriate facilities, equipment and supplies necessary to produce the Picture. The cost of providing the Services will be the sole responsibility of Partnership B and will include all reasonable and necessary production and operating costs, fees and expenses incurred as a result of the production of the Services, including without limitation, employee and contractor salaries, fees, general and administrative expenses, equipment costs, and expendable supplies and parts costs for the production of the Picture.
The U.S. producer will grant a loan to Partnership B to enable it to pay the expenses as the capital contribution of Partnership A to Partnership B will be made only after the expenses will be incurred. The loan will be partly reimbursed by the capital injected by Partnership A. The capital contribution of Partnership A to Partnership B is expected to be equal to half (50%) of the aggregate of the expenses incurred by Partnership B. Therefore, Partnership B will reimburse half (50 %) of the producer's loan after the investment has been made by the Partnership A.
The producer's loan, the expenses incurred by the Partnership B, the capital contribution of Partnership A to Partnership B and the partial reimbursement of the producer's loan will all occur in the first fiscal period of Partnership A and of Partnership B. However, Partnership B will earn income only after the end of its first fiscal period. Therefore, Partnership B will realize a loss in its first fiscal period, the amount of which will depend on the amount of expenses deducted in respect of that fiscal period. It is submitted by the taxpayer that under GAAP, since the fees "reasonably likely" to be earned by Partnership B will in fact be equal to an amount corresponding to half (50 %) of the expenses incurred, the expenses in excess of that amount "reasonably likely" to be earned shall be deducted in the fiscal period in which these expenses were incurred, i.e. in the first fiscal period of Partnership B. The rest of the expenses would have to be amortized against the revenues earned in the following fiscal periods. The revenues earned by Partnership B will probably not exceed the deductions that it will be able to take in its fiscal periods following its first fiscal period. Therefore, Partnership B will have a loss equal to half (50 %) of its expenses in its first fiscal period and will earn revenues in its subsequent fiscal periods in respect of which deductions will be available to offset the revenue earned.
Ownership of all results and proceeds of the Services, including any tangible property and equipment purchased and supplied as part of the Services, will rest in and be retained by the U.S. producer. The U.S. producer will own all copyrights and rights of exploitation in and to the Picture. Partnership B will neither own nor acquire any interest in the Picture, will have no right of any kind in or to any copyrights therein or thereto, and will have no right of management or control over the exploitation of the Picture.
2. AREAS OF CONCERN AND THE DEPARTMENT'S POSITION
(1) Deductibility of the expenses
Rulings Directorate will be asked to give a ruling that the
expenses incurred by Partnership B in excess of the amount
of fees "reasonably likely" to be earned by it (i.e. an
amount equal to the capital contribution of Partnership A to
Partnership B) will be deductible in the year incurred. Such
a ruling will be issued SUBJECT to three conditions. (a) Reasonable expectation of profit
The expenses will be deductible only to the extent
they are made or incurred for the purpose of gaining
or producing income from a business with a
reasonable expectation of profit. (b) Nature of the expenses (current vs capital)
Normally, should the US producer himself incur the
expenses, the expenses would be capitalized to the
cost of the Picture and the amortization of these
expenses would be SUBJECT to the leasing property
rules because the Picture would not qualify as a
"certified production". The ruling on the deductibility of the expenses
incurred by Partnership B will contain a caveat
that the expenses are not on account of capital.
However, on the basis of the Federal Court Trial
Division in Asamera Oil (Indonesia) Ltd. v.
The Queen (
73 DTC 5274), salaries, wages, rent,
supplies and other expenses which are normally current
in nature would not usually be considered as incurred
on capital account in this context. (c) Timing of the deduction of the expenses
Since it is impossible to issue a ruling on the timing
of the deduction of expenses under GAAP, the ruling
will usually contain a caveat that the expenses
are deductible to the extent the said deduction is in
conformity with GAAP.
(2) Deductibility of interest
Rulings Directorate will be asked to rule on the
deductibility of interest incurred by the investors on the
amount borrowed by them for the purpose of buying units in
Partnership A and on the deductibility of interest incurred
by Partnership B on the loan granted by the US producer to
enable Partnership B to pay the expenses. Rulings will be issued in respect of the deductibility of
the interest expense incurred by the investors and
Partnership B to the extent the amount thereof is reasonable
and is payable pursuant to a legal obligation to pay
interest on borrowed money used for the purpose of earning
income from a business or property with a reasonable
expectation of profit.
(3) Application of the General Anti-Avoidance Rule
A ruling on the application of GAAR may also be requested by
the taxpayer. GAAR may apply or some other avoidance provision,
(i) Where under the Production Services Agreement, the
expenses that would be capital expenditures for the
U.S. producer if he had incurred them are current
expenses for Partnership B; (ii) If it appears that the only motivation for the
investors to invest in Partnership A is the
opportunity for them to deduct the tax losses of
Partnership B and to receive a reimbursement of
capital which, combined with the tax loss deduction,
would give them a good return on their investment. (iii) Where the Picture which will be produced under the
Production Services Agreement does not meet the
criteria to qualify as a "certified film production"
and would have been SUBJECT to the leasing property
rules (i.e. no deduction of CCA if no income) if it
had been held by Partnership B. Thus, if the structure
has the effect of circumventing the restrictions on
certified production qualification and leasing
property rules and will achieve at least the same tax
benefit conferred upon the acquisition of certified
productions without any guarantee that all the
Canadian content requirements thereof will be met, tax
deductions would then be obtained in Canada by the
investors and not enough income would be coming to
Canada to make the structure viable for the investors
had they not obtained the tax deductions.
3. REFERENCES
A. Income Tax Act
Section 9: computation of the income from a business
Paragraph 18(1)a): earning purpose test
Paragraph 18(1)b): disallowance of capital expenditure
Paragraph 20(1)c): deductibility of interest
Paragraph 53(2)c): adjustment to the adjusted cost base of
an interest in a partnership
Subsections 96(2.1), (2.2), (2.3) to (2.7): limited
partnership losses and at-risk amount.
Section 237.1: Tax Shelters defined B. Court Cases
Asamera Oil (Indonesia) Limited v. The Queen,
73 DTC 5274 (FCTD)
Deputy Minister of Revenue of Quebec v. Julius
Lipson, (1979) 1 S.C.R. 833 (SCC)
Luigi Tiengo Art & Design Inc. v. M.N.R.,
91 DTC 1216 (TCC) C. Publications
Jeffrey Mandel, "Tax Shelters in the 1990s", in Report of
Proceeding of the Forty-Third Tax Conference, 1991
Conference Report (Toronto: Canadian Tax Foundation), 1992,
at 35:1.Approved by: Date:
Appendix
Example
Assume a Canadian limited partnership that has only one
limited partner and in which the general partner contributes
a nominal amount for its partnership interest. The limited
partner contributes 100 $ for its partnership interest. The
partnership buys 100 % of a certified production for 200 $
of which 100 $ is borrowed from a U.S. corporation ("the
lender") which is related to the producer and distributor of
the certified production. The loan will bear interest at a
commercial arm's length rate of interest. The partnership
will have a capital cost of 200 $ in the certified
production. It is not reduced by reason of the fact that
$100 of the purchase price was borrowed or by the benefit
resulting from the prescribed revenue guarantee.
The partnership will earn revenue of 90 $,in year 2, from a
prescribed revenue guarantee given in respect of the
property. The partnership will deduct CCA of 60 $ in year 1
and 90 $ in year 2 to reduce its income to nil. The
partnership allocates the loss of $60 in year 1 to the
limited partner. Scenario 1—Put option
The limited partner will have the right to sell to the
lender his partnership interest at fair market value. No
income (including the revenue guarantee) will be recognized
in the partnership before the exercise of the "put option".
The FMV of the partnership interest should equal the amount
of the revenue guarantee. An investor who is in the 50% tax bracket would save $30 in
taxes in year 1. If we assume that the FMV of his unit
equals the amount of the revenue guarantee, the limited
partner would realize, in year 2, a capital gain of $ 50
(90 - 40 = $50) of which $ 37.5 (or 75%) would be taxable.
He would also have received cash of $90. For an outlay of
$100 the investor would receive $101. The following illustrates the results to the limited
partner: UCC CCA Inc./Loss Cash on hand ACB
200 100
Year 1 (60) 60 (60) 30 (tax saved) (60)
140 40 Year 2 (90) 90 nil 90 (put option)
(19)(tax on TCG)
50 101 As mentioned on page 14, Rulings Directorate will be
prepared to rule favourably in a situation where the put is
exercised after the limited partner has recognized income at
least equal to the revenue guarantee. Scenario 2—Conversion of debt into partnership
interest No put option is offered to the limited partner. The lender
will have the option to convert its loan into a partnership
interest immediately after the payment of the revenue
guarantee. All income and cash will be paid to the limited
partner until he has received revenue under the revenue
guarantee of 90 $. The partnership agreement will provide
that all additional revenues of the partnership in excess of
the revenue guarantee will be allocated to the
lender/partner to recoup its investment in the partnership.
Subsequently, the two partners will share income and cash in
proportion to their interest in the partnership. In scenario 2, the partnership allocates the loss in year 1
and the income (nil) in year 2 to the limited partner. In
year 2, it distributes $90 to the limited partner. However,
since the at-risk amount of the limited partner is $100 at
the end of year 1 the deduction by the limited partner of
$60 in year 1 is permitted by subsection 96(2.1) of the Act
and it is not affected by the distribution of the $90 cash
which results in the partner's ACB becoming negative (-$50). UCC CCA Inc./Loss Cash on hand ACB
200 100
Year 1 (60) 60 ( 60 ) 30 (tax saved) (60)
140 40 Year 2 (90) 90 nil 90 (90)
50 120
(50)
A limited partner who is in the 50% tax bracket would save
$30 in taxes in year 1 and would receive cash from the
partnership totalling $90. For an outlay of $100 the
limited partner would receive $120. The adjusted cost base
of the partnership interest would be negative but subsection
40(3) of the Act does not apply to deem a gain to have been
realized by the limited partner. There would be a potential
tax payable of $ 19 on the negative ACB when the limited
partner disposes of his interest in the partnership. The
cash flow situation of the limited partner could be compared
with the one arising from the put option. Scenario 3—No put option, no conversion of debt
The loan will be repayable no later than 6 years from the
date of disbursement. At the end of the 6 years term, the
lender will be entitled to foreclose on the assets of the
partnership, if the loan has not been fully repaid. All
income and cash will be paid to the limited partner until he
has received revenue under the revenue guarantee of 90 $.
Thereafter, all additional revenues of the partnership in
excess of the revenue guarantee will be applied to reduce
the balance of the loan; however, until the loan is repaid
all income (up to $100) will be allocated through the
partnership to the limited partner. Also, the lender will
have the option of subscribing for limited partnership units
at the earlier of the time at which the balance of the loan
is repaid and the expiry of the term of the loan for an
amount equal to the then fair market value of such units.
For the first two years, the tax consequences for the
investor would be the same as those described in
scenario 2. In year 3, the partnership would deduct CCA of
$50 to reduce its income from $100 to $50. The investor
would pay taxes of $25 on the allocation of income of $50
from the partnership. For an outlay of $100, the investor
would receive $95. UCC CCA Inc./Loss Cash on hand ACB
200 100
Year 1 (60) 60 ( 60 ) 30 (tax saved) (60)
140 40 Year 2 (90) 90 nil 90 (90)
50 (50) Year 3 (50) 50 50 (25) 50
0 95 0 The lender would subscribe for limited partnership units.
The purpose of this investment would be to give an
appropriate return to the investor via a possible
distribution of capital and to allow the lender to become an
owner of the TV series via the limited partnership. The
investor's ACB would become negative but he would stay as a
partner. In this situation, we could question if the loan
has been repaid. Scenario 4—Transfer into a Canadian Corporation
The loan will be repayable in 8 years. The limited partner
is required to transfer his limited partnership interest to
a Canadian corporation in return for shares of that
corporation within 5 years of the date of disbursement of
the loan. At the beginning of year 3, the Canadian
corporation would acquire the limited partnership interest
from the limited partner at fair market value and would give
common shares as consideration. The transfer will be done
pursuant to section 85 of the Act and an elected amount of
$1 will be selected resulting in a capital gain of $50 i.e.
equal to the then negative ACB of the limited partner's
interest. Tax of $19 would be payable by the limited
partner on a taxable capital gain of $37.5. One more time,
the cash flow situation of the limited partner could be
compared to the one arising from the put option. Future
income from the TV series would be taxable in the Canadian
corporation.All rights reserved. Permission is granted to electronically copy and to print in hard copy for internal use only. No part of this information may be reproduced, modified, transmitted or redistributed in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, or stored in a retrieval system for any purpose other than noted above (including sales), without prior written permission of Canada Revenue Agency, Ottawa, Ontario K1A 0L5
© Her Majesty the Queen in Right of Canada, 1993
Tous droits réservés. Il est permis de copier sous forme électronique ou d'imprimer pour un usage interne seulement. Toutefois, il est interdit de reproduire, de modifier, de transmettre ou de redistributer de l'information, sous quelque forme ou par quelque moyen que ce soit, de facon électronique, méchanique, photocopies ou autre, ou par stockage dans des systèmes d'extraction ou pour tout usage autre que ceux susmentionnés (incluant pour fin commerciale), sans l'autorisation écrite préalable de l'Agence du revenu du Canada, Ottawa, Ontario K1A 0L5.
© Sa Majesté la Reine du Chef du Canada, 1993
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