15 October 1982 Income Tax Severed Letter

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.

October 15, 1982

POSITION PAPER ON MOTION PICTURE FILMS AND VIDEOTAPES AS TAX SHELTERS

FILMS

DESCRIPTION OF THE TAX SHELTER

To encourage the production of motion picture films in Canada the Income Tax Regulations permit the deduction of capital cost allowance in computing income for tax purposes of any amount up to 100% of the capital cost of a motion picture film or videotape which is a "certified feature production" or "certified short production" (certified productions), certified as such by the Minister of Communications, for a Canadian taxpayer who acquires his interest for the purpose of earning income from property. The investor must acquire ownership of an asset which qualifies under class 12 of Schedule II of the Regulations in order to claim CCA at the maximum rate of 100%. This CCA may be claimed in full against ordinary income from any source since a certified production is not a leasing property by virtue of paragraph 1100(17)(c) of the Regulations. If the film produced will not qualify as a class 12 asset, the investor is subject to the "leasing property" rules in the Regulations under which the investor's interest would become a class 10 asset. Where the film is a class 10 asset, 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 from this investment and such other "leasing properties", owned by him.

A significant tax shelter feature is that the investor may acquire his interest with a cash outlay of 20% of the cost of that interest and have four years to pay the balance. Thus, for a $1,000 cash outlay, an investor way deduct $5,000 in computing his income and, if his marginal tax rate is 50%, he will have a tax reduction of $2,500.

HISTORY OF FILMS AS A TAX SHELTER

Prior to the enactment of the current legislation in December, 1978, there was much uncertainty and confusion concerning motion picture films as tax shelters. Furthermore, the Department, based on its review of numerous different arrangements, became aware of abuses. Those areas that disturbed us the most were:

(1) the capital cost of a film in relation to the amount the investor had "at risk"; and

(2) the point at which a depreciable asset existed, i.e. timing of completion of a film's "principal photography".

(1) AT RISK and CAPITAL COST

This was the most significant area of disagreement since investors claimed a stepped-up depreciable cost base by artificially inflating the cost through the use of non-recourse, contingent or no risk debt as part of the purchase price. If non-recourse debt were allowed to form part of a taxpayer's cost then a deduction substantially in excess of what had actually been at risk, would have been achieved.

There were a number of Court decisions supporting the Department's position that non-recourse or contingent debt could not constitute part of the capital cost of a film to an investor for CCA purposes (Handel v. The Queen, 80 DTC 6148, Mckee v. The Queen, 77 DTC 5345, C. Ralph Lipper v. The Queen, 79 DTC 5246). In addition, 'risk reducers' in the form of revenue guarantees (minimum royalties or licence fees payable to investors in a film and unconditionally and irrevocably guaranteed by a third party) became popular prior to the enactment of the present Regulations. The protection of the income stream became offensive to the 'at risk' rules and the Department contended that such arrangements might have been structured to return the investor's money to him in the guise of income. Although we had no tax law to deny CCA on the guaranteed portion of the investor's purchase price, rulings were refused where there were such revenue guarantees in the hopes of stopping such arrangements. We contended that any such proposed transactions were not designed primarily for business purposes but rather designed to gain an advantage by tax deferral.

(2) PRINCIPAL PHOTOGRAPHY

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.

Revenue Canada's Changing Positions

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. IT-441 was issued in November 1979 and sets forth our interpretation of the numerous aspects which must be considered and covered in all advance rulings given. That bulletin has caused no major policy concerns and no amendments to the bulletin are presently in the works. The new half-year CCA rules proposed in the November 1961 budget (as amended on December 1978, 1981) will be deferred until 1983 for investments in certified productions.

Requirements for Advance Rulings

GENERAL

Paragraphs (a) and (b) of the definitions of a "certified feature production" and a "certified short 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 roles.

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. The actual ownership requirements are not specified in the Act or the Regulations. 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 ruling, the facts must reflect, or we must be otherwise satisfied that:

(1) 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 shorts, ownership in each film 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 of IT-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 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 );

(iv) the revenue will be shared by all the investors in proportion to their interest and will be made up of all companies received from the exploitation of the film. (In the case of a 'series' of shorts, the investor must share in all revenue derived from the exploitation of each film in which he has an interest);

(v) the revenue will be distributed on a timely basis such as every 6 months or at least once a year and the investors will recoup the full cost of their investment out of revenue derived from the exploitation of the Film before any other distributions are made;

(vi) the Completion Guarantor will have full recoupment of any funds which he has been required to spend to complete the film out of the next dollars of revenue after the investors have full recoupment referred to in (v) above. (As part of the arrangement, it is usually specified that the investors will not be required to furnish any sums in addition to their investment in order to complete the film);

(vii) there will be a reasonable basis for sharing revenue thereafter (refer to (v) and (vi)) in light of percentages of ownership;

(viii) the appointment of a custodian such as a trust company will result in a fiduciary relationship with the investors, at a reasonable fee for such services.

CERTIFICATION

Paragraphs 1104(2)(a) and (b) of the Regulations

Under 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.

Other Requirements for Certified Productions

In addition, the film will not be a certified production if:

(a) the investor acquired his interest after 1976 and after 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 1104(2)(c) of the Regulations)

(The comments in paragraph 9 of IT-441 re first commercial use should be noted).

(b) the investor acquired his interest from a non-resident; (paragraph 1104(2)(f) of the Regulations)

(c) the certificate has been revoked by the Minister of Communications as a result of an incorrect statement made in furnishing the information for certification. (paragraph 1104(2)(g) of the Regulations)

Financing Requirements in order to qualify as a Certified Production

At least 20% of the capital cost of the film to the investor must be paid in cash as of the end of the year (paragraph 1104(2)(d)). The balance may be financed by the issuance of a note or similar obligation which must be due in full before the end of the fourth taxation year after the taxation year in which the investor acquires his interest in the film (paragraph 1104(2)(e) of the regulations). Interest on any obligation issued should be at a commercial rate of interest. Otherwise the note must be discounted to reflect its present value and the discounted value must be used in the calculation of capital cost. (Paragraph 10 of IT-441 ).

The debt must also be a "full recourse" debt (paragraph 11 of IT-441 ). For purposes of an advance ruling regarding the 'capital cost' of a film, an irrevocable letter of credit or similar form of guarantee issued by a Canadian chartered bank or Trust Company must be given in respect of the unpaid balance of the purchase price. The term of such letter of credit must not expire before the due date of the note. (Refer to Decision Summary on 20(1)(a), Reg. 1104, dated July 9, 1982). Further, the investor must assign his share of the income in respect of the film first in payment of accrued interest on any note and secondly in payment of the note until such note is paid in full as evidence that the note is bona fide.

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 80% 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.

Timing of CCA

1. The Department has adopted the position (see above comments on 'history') that principal photography of the film must be completed by the end of the taxation year and the investor must own his unit at that time to be eligible for the 100% CCA. (Refer to paragraph 14(a) of 1T-441).

The Regulations do not specifically state this but support in law is found as follows:

The preamble to the paragraphs in the definitions of certified 'features' and 'shorts' in Regulation 1104(2) refer to 'principal photography (which) was commenced before the end of the particular taxation year or was completed no later than 60 days after the end of the particular taxation year etc. Then Regulation 1100(21)(a) provides for a limited CCA deduction where principal photography is not completed before the end of the particular taxation year for the situations where

(a) principal photography is completed wiithin 60 days after the end of the year (whether or not it commenced during the year) or

(b) principal photography commenced before the end of the taxation year but was not completed within 60 days after the end of the year.

2. In case of 1(a) above, paragraphs 1100(21)(a)(i) and (ii) of the Regulations deny CCA to the extent of the excess of the cost of the film to the investor over his proportionate share of the production costs incurred in respect of the film. In other words, the investor is entitled to his 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 ).

3. In the case of 1(b) above, paragraphs 1100(21)(a)(i) and (iii) of the Regulations deny CCA to the extent of the excess of the cost of the film to the investor over the lesser of his 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%.

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. Generally, paragraphs 1100(21)(b), (c) and (d) of the Regulations are designed to deny CCA on that portion of the investment in the film which is covered by a revenue guarantee. These paragraphs deal with certain arm's length situations, certain non-arm's length situations and "other" situations, respectively.

Where there is a revenue guarantee, we are most often concerned with paragraph 1100(21)(b) and, having regard to conditions that must be satisfied, whether or not "it may reasonably be considered certain, having regard to all the circumstances, that the investor will receive revenue" etc., at any time before the later of the two times specified thereunder. However, as indicated in paragraph 19 of 1T-441, the contractual conditions must be substantive (and not merely a window dressing - some examples are provided in the Bulletin). Unless there is a reasonable degree of risk or uncertainty that the conditions can in fact, be fullfilled (i.e. at the later of the date of completion of principal photography or the date the particular investor acquires his interest in the film), an investor will not be permitted to claim CCA until the year he includes the amount of the guarantee in income.

Return of Funds to an Investor

There is usually provision in the purchase agreement to return funds to an investor if the film is produced for less than the budgeted amount. As a policy, if the amount returned to an investor is 5% or less of the capital cost of the film, an investor may credit his class in the year the funds are returned; otherwise the effect must be taken into account in the year the film is acquired (Paragraph 22 of 1T-441). Also, it is a condition that any entitlement to a return of funds must first reduce any outstanding interest and debt obligations to ensure that the requirement that at least 20% of the cost of the film be paid in cash, will still exist (paragraph 23 of IT-441 ).

Other General Premises on which Advance Rulings are based

1. There is usually an assumption that the Producer and all investors are dealing at arm's length. If this is not the case, then there is an understanding that non-arm's length investors will purchase film units on the same terms and conditions as the arm's length investors. This will ensure that any provisions of the Act such as section 69 dealing with non arm's length transactions will not be a problem where such section(s) are not usually part of the request for a ruling for films.

2. There is an assumption of fact in the ruling that none of the investors is in the business of buying and selling interests in motion picture films. Otherwise, the film costs would be considered inventory and therefore not depreciable.

3. Furthermore, there is an assumption that the investors will acquire their film units as capital property to derive property income therefrom. The concern here generally is that the investors will not be subject to subsection 1100(3) of the Regulations which limits the capital cost allowance that can be claimed in respect of a business when the fiscal period of the business is less than 365 days.

Commercial Arrangements Limited partnerships have been used although such arrangements are less attractive since CCA would be claimed at the partnership level which would not provide the flexibility desired. As well, the partnership would be considered to be carrying on business and be subject to the provisions of subsection 1100(3) so that an investor putting up his money near December 31 could not get the immediate 100% write-off.

The usual arrangement is a sale of units on a direct participation basis with the producer of the film. Each unit constitutes an undivided proprietary interest in all components of the file.

Unresolved Problems

We are presently seeking guidance from our legal advisors in respect of the degree of control investors must retain over the film in order to be considered to "own" a depreciable property rather than merely a non-depreciable right to share in profits from the exploitation of the film.

Prepared by:

ORIGINAL SIGNED BY Approved by:

Chief Services, Public Utilities & Exempt Corporations Section Corporate Rulings Division.