Satya Poddar is national director of tax policy services at Ernst & Young L.P.

After three years of dialogue with the industry, the Department of Finance presented new rules for the Canadian Film or Video Production Tax Credit in November. The changes are designed to improve the tax incentive, but early reaction to the new rules has been decidedly mixed.

The industry has been pushing Ottawa to simplify the computation of the tax credit and to enhance its value.

On both fronts, the gains are far less than what the industry had asked for and anticipated.

Canadian certified film and video production volumes have been declining since 1999. The volume of foreign production has also gone down since the withdrawal of tax shelter benefits in September 2001. While many factors have contributed to the current slump, the CFVPTC (which is calculated at 25% of labor expenditures for a production) is an increasingly important financing component for domestic productions. An insufficient enrichment to the credit means that producers will continue to struggle in an increasingly difficult environment.

The two most important changes announced by the government are an increase to the maximum limit for the production labor that qualifies for the tax credit and a modified treatment of equity funding by Telefilm Canada, and other government agencies and broadcasters.

Under the new rules, the cap on labor expenditures eligible for the credit increased from 48% to 60% of the total budget for a film or video production.

Currently, a producer is denied to claim any tax credit in respect of production expenditures funded through equity participation from Telefilm or broadcasters. Both labor and non-labor expenditures of the producer are reduced by the percentage equity participation of such agencies.

Under the new rules, equity participation by Telefilm (and other prescribed government agencies) will reduce only the total budget, but not the labor expenditures. Equity funding by broadcasters will reduce neither the total budget nor the labor expenditures. It is likely that equity by private funds will also be treated the same as by broadcasters.

As a result, all labor expenditures on a production will qualify for the 25% tax credit, subject to the new cap of 60% of total budget, regardless of the nature and extent of equity participation by such persons. It is estimated that these two changes could enhance the effective value of the credit by two percentage points, from approximately 10.5% of the total budget to 12.5%.

These changes, while beneficial, go only part of the way in meeting the industry demands to eliminate altogether any adjustment or grind for Telefilm or broadcaster equity. Interestingly, Quebec does not grind the tax-credit base by the amount of government equity. In the 2003 budget, Ontario also announced an elimination of the equity grind. It is uncertain whether the new Liberal government in Ontario will honor that commitment.

Offsetting the benefits of the CFVPTC changes is the disqualification of non-resident labor for the credit. An exception has been made for labor expenditures in respect of Canadian citizens, which would remain eligible regardless where they reside. The restriction on non-resident labor could be significant for animation productions which outsource animation work to low-cost jurisdictions abroad.

Another major change in the rules relates to the so-called investor restriction. The old rules disqualified a production for the tax credit if any investor, other than the producer, claimed a tax deduction in respect of the production. The definition of investor for this purpose was so broad that even the deduction of interest paid by a bank to its depositors to fund a loan to the film producer could disqualify the film for the tax credit.

The good news is that this investor restriction has been removed under the new rules. However, the bad news is that the investor restriction was only one part of the problem that producers faced when structuring financing deals.

The second difficulty pertains to the Canada Revenue Agency’s interpretation of the requirement that the production company must own exclusive worldwide copyright in a production (other than a treaty coproduction) for a minimum of 25 years in order to claim the tax credit.

The CRA is of the view where a film distributor makes an advance to obtain distribution rights in particular territories and negotiates for a participation in the worldwide net profits of the production, the distributor could be viewed as having acquired a beneficial ownership of the copyright if the profit participation was unacceptably large. In the past, the CRA has not shied away from denying the tax credit to a production in such circumstances, even where it has been certified by CAVCO to meet the copyright ownership requirements.

The line between acceptable financing structures and unacceptable structures is vague and arbitrary. It has been nearly impossible to get advance clearance of financing structures. The CRA would rarely provide an interpretation on a production in advance without the production company applying for a formal advance income-tax ruling, which typically takes several months. The producers of The Big Comfy Couch spent years in litigation before the Tax Court finally concluded that their series of financing agreements did not infringe the copyright rules.

By only removing the investor restriction, the Department of Finance has not fully resolved the problem. The CRA is not likely to change its position on situations where third-party investors may be considered to have acquired a portion of the copyright in the production. Unless the legislation is appropriately modified, the potential for credit denial remains.

In place of the investor restriction, Finance has now introduced a new restriction on film productions that qualify in a tax-shelter arrangement. Ordinarily, a tax shelter exists where representations are made to investors that the total of tax deductions over four years will exceed the cost of an investment. Given the tight restrictions on deductibility of costs for a Canadian production for anyone other than the production company, it is difficult to imagine that an investment in a Canadian production could ever be a tax shelter.

However, the tax-shelter rules are exceptionally broad and could catch situations that would not otherwise be thought of as tax shelters. For example, it is possible that an investment in a production could be considered to be a tax shelter if the investors are provided with guaranteed returns as a result of presales. This kind of determination would certainly wreak havoc with any producer trying to solicit investors on this basis.

In light of these uncertainties and troubled times, it is difficult to determine exactly what kind of impact the new film tax-credit rules will have on film productions in Canada and on the bottom line of the producers. However, film and television producers have proven to be resilient, and are accustomed to living through uncertainty. They will continue to be faced with making creative use of limited financial resources in order to survive the current state of affairs.

Written in association with Norm Bacal. Norm is managing partner at Heenan Blaikie LLP.