they dead or alive?

mary-ann haney is a tax lawyer and a member of the Communications Group of the Toronto law firm McMillan Binch.

The recent federal budget proposed two changes to the rules in the Income Tax Act (Canada) that deal with film tax shelters. Tax shelters have been a significant source of revenue for Canadian film and television producers and, at first glance, the proposed changes appear to affect the viability of film tax shelters. The expansion of the transitional rules announced on March 30, however, appears to allow many productions to access tax-shelter financing. After that, who knows?

Existing tax shelters

Most of the pre-budget tax shelters share several common characteristics although there are numerous variations on the basic theme. A typical pre-budget tax shelter involves the following four basic elements:

(i) the purchase by a limited partnership of a ‘certified production’ (a film or television program that meets the Canadian content requirements in the Act or a treaty coproduction);

(ii) a distribution agreement between the partnership and a distributor affiliated with the producer which provides for a revenue guarantee payable to the partnership;

(iii) the purchase by investors of units in the partnership for an amount equal to the cost of setting up the structure and about half the cost of the production; and

(iv) a loan from another affiliate of the producer in an amount representing the remaining cost of the production, where repayment of this loan is subordinated to the investors’ right to receive the proceeds of the revenue guarantee and convertible into an interest in the partnership after the revenue guarantee has been paid to the investors.

Once this structure is established, the partnership claims Capital Cost Allowance (cca) based on its cost of the program (about twice the amount invested by the limited partners in the productions) and the resulting loss is flowed-out to the investors and deducted from their incomes for tax purposes. In the next year, the revenue guarantee is paid to the partnership and distributed to the investors. At this point, when the tax savings resulting from the deduction of cca are taken into account, investors have recovered the amount invested in the partnership and earned a fairly significant return on their investment.

The ugly legacy of an investment in a film tax shelter is a ‘negative adjusted cost base.’ This ‘negative acb’ arises because the amount of partnership losses flowed out to an investor and the amount of the revenue guarantee distributed to the investor exceeds the amount originally invested in the partnership.

A negative acb is taxed as a capital gain when the Act requires it to be recognized. Under the existing tax rules, a partnership is unique since an investor is not required to recognize a negative acb when it is created by the distribution of the revenue guarantee but only when the investor dies or transfers his units or when the partnership is wound up.

This deferral of the capital gain associated with the negative acb for several years after the revenue guarantee is distributed to the investors is a critical feature of existing tax shelters. The longer the period between the enjoyment by an investor of the tax benefits associated with his investment in the tax shelter and the time he has to pay the tax on this capital gain, the more attractive the tax shelter.

Proposed amendments

The proposed amendments attack two of the key features of these film tax shelters – the convertible subordinated loan and the negative acb.

Convertible loans: under the proposed amendments, a partnership’s cost of a production will be reduced by the amount of any convertible loan used to finance the acquisition of the production until the loan is converted into an interest in the partnership.

The effect of this change is that the partnership’s cca deductions and the amount of the losses available to investors will be based only on the amount of the investors’ investment in the partnership. Under this regime, the tax deduction available to investors would be 30% of their investment in the partnership, instead of the approximately 60% tax deduction that is available under the existing rules.

Negative acb: under the proposed amendments, an investor will be required to recognize, and pay tax on, the capital gain associated with his negative acb in the year in which the revenue guarantee is distributed. In short, the proposed amendments eliminate the ability to defer this capital gain.

Grandfathering rules

Under the grandfathering rules included in the budget, tax-shelter financing would not have been available for many 1994 productions since the tax shelters to which they would have been sold were not sufficiently advanced by the budget date to be grandfathered.

On March 30, 1994, in response to submissions from industry representatives, the minister of finance announced that the grandfathering rules for film tax shelters would be expanded. These new rules will make tax-shelter financing available for many more 1994 productions.

In general, the new grandfathering rules provide that the proposed amendments will not apply to transactions entered into pursuant to (i) a prospectus, preliminary prospectus or offering memorandum filed with the securities authorities before Feb. 22, 1994 or (ii) an offering memorandum distributed before Feb. 22, 1994, provided that partnership units are sold before Jan. 1. 1995 and principal photography begins before Jan. 1, 1995 and is completed before March 1, 1995.

The new grandfathering rules also defer the application of the negative acb rule until 1999, and the convertible subordinated debt rule until 1995 where a partnership acquires a production from a producer before 1995 and one of the following conditions are satisfied: (i) the producer entered into an agreement before Feb. 22, 1994 for the pre-production, distribution, broadcasting or acquisition of the production or the screenplay for the production; (ii) the producer received a commitment for government funding before 1995; or (iii) the production is a continuation of a series and one of the episodes satisfies the requirements in (i) above. These grandfathering rules will only apply if partnership units are sold before Jan. 1, 1995 and the principal photography of the production commences before January 1995 and is completed before March 1, 1995.

These grandfathering rules will only apply if partnership units are sold before Jan. 1, 1995 and the principal photography of the production commences before January 1995 and is completed before March 1, 1995.

Is tax shelter financing dead?

It is clear that many of the existing tax-shelter structures will not be viable after the transitional relief provided by the grandfathering rules is no longer available. But to say the film tax shelter is dead would be to underestimate those who invent these structures and the need for this type of financing in the industry.

Film tax shelters were reinvented when the cca rate applicable to ‘certified productions’ was reduced from 100% to 30% in 1987 and it is quite possible that they will be reinvented again to deal with the proposed amendments. The rumors of the death of the film tax shelter may be greatly exaggerated.

this article contains general comments only. It is not intended to be exhaustive and should not be considered advice on any particular situation.