Recent Changes in Independent Production and Interim Financing of Film and Television Productions in Canada

In 2003 a downturn in the Canadian independent production industry had arisen due to a convergence of a depressed sales market, an increased public appetite for reality programming, reduced government support and foreign competition for global production dollars. In 2004 this "perfect storm" raged on and grew stronger, and the year was also witness to further sweeping changes impacting the Canadian industry: (i) increasingly aggressive measures adopted by other jurisdictions to attract production dollars; (ii) the shuttering of Alliance Atlantis's production division, which was once the largest in Canada; and (iii) tougher requirements for qualifying under our co-production treaty with the U.K., our largest English-language co-producing partner.

Consider the fate of the Banff Television Festival, which is held annually in June. In the weeks prior to the 25th anniversary of the event, festival organizers announced that the festival was on the verge of collapse due to, among others reasons, the effects of SARS, "mad cow" disease and the resulting fall-off in attendance and sponsorship revenues. A last-minute intervention by a group of investors saved the festival for 2004, and there are plans to continue the festival in future years. Many industry observers could not help but draw a direct parallel between the state of the Canadian industry and the woes of the Banff festival.

The silver lining among the dark clouds was the outstanding success of Denys Arcand'sLes Invasions Barbares (The Barbarian Invasions) . Arcand's film premiered at the 2003 Cannes Film Festival, where it won the screenplay award and best-actress honours. At the Academy Awards in February, the film won the Oscar for best foreign-language film—the first Canadian film to win that prize. Later in the year, the film dominated the Genies, the Canadian version of the Oscars, where it won six major awards. The success ofLes Invasions Barbares is proof positive of the health of the French-language film industry in Canada, relative to its English-language counterpart.

Despite this success, the Canadian production statistics for 2004 showed a marked decline from previous years, especially in the traditionally larger production centers, such as Vancouver, Toronto and Montreal. Although some of the production ordinarily produced in these cities has moved to regional centers, such as Winnipeg and Halifax, the view of most industry participants is that the overall level of production has decreased.

CANADIAN RESPONSES AND DEVELOPMENTS: ENHANCING THE CANADIAN TAX CREDITS

The federal content tax credit, known as the Canadian film or video production tax credit, is calculated as a percentage of the Canadian labour expenditures incurred by a Canadian producer in connection with an eligible production. When this credit was introduced in 1995, the percentage was 25% of qualifying Canadian labour expenditures, which were capped at 48% of the eligible production budget, yielding a credit of up to 12% of the eligible production budget. In November 2003, the cap on expenditures was increased to 60% of the eligible production budget, yielding a credit of up to 15% of the eligible production budget. Statistics are not yet available to determine the impact of the changes to the federal content credit, but the increase was certainly welcomed by producers.

The federal production services tax credit ("PSTC") is calculated as a percentage of the qualified Canadian labour expenditures incurred by the owner of copyright in an eligible production, or by a production services provider engaged by such a copyright owner. Following the elimination of production services tax shelters in September 2001, the federal government committed to increasing the PSTC. In February 2003 the PSTC was increased from 11% to 16% of qualifying Canadian labour expenditures. The initial response to the increase was positive, but by late 2004 production services activity had decreased sharply in Vancouver, Toronto and Montreal. The decrease is significant enough to question the lasting effects of the 2003 increase to the PSTC.

CHANGES TO THE TAX CREDIT "INVESTOR RULES"

The federal content tax credit contained provisions that restricted the payment of such credit where an ineligible "investor" could claim a tax deduction in respect of the relevant production. These "investor rules" were specifically designed to prevent producers from accessing both the content tax credits and the benefits of selling accelerated tax deductions to investors. Although the investor rules permitted certain investments by "prescribed persons," such as investments by governmental film agencies or broadcasters licensed by the Canadian Radio-television and Telecommunications Commission ("CRTC"), most private investment was excluded. Moreover, the consequence of permitting an investment by anyone other than a prescribed person is that the content tax credit is reduced to zero.

Canadian producers were originally willing to accept the bright line between tax credits and private investment because they were the constituency that had lobbied the government to introduce the content tax credit as an alternative to the private investments previously available through tax shelters. Yet no one was certain how broadly the investor rules would be interpreted or applied. In 1999 the Canada Revenue Agency ("CRA") circulated draft guidelines for the content tax credit, suggesting that any acquisition of a beneficial interest in a production's copyright would contravene the investor rules. One result of this interpretation was that broadcasters, distributors, talent and other recipients of net profit participations could be considered ineligible investors, which was clearly not the original intent of the content tax credit legislation.

In November 2003, after considerable consultation with industry participants, the federal Department of Finance ("Finance") proposed amendments to clarify the investor rules. These amendments deleted the general prohibition against investors claiming tax deductions in respect of a production and replaced it with a specific prohibition against tax shelter investments. By clarifying that it is tax shelter investments that are to be excluded from the content tax credit regime, Finance has attempted to reinforce the original legislative intent of such regime.

Unfortunately, the proposed amendments to the investor rules did not change the provisions in the content tax credit regulations that preclude an "excluded production" from receiving the credit. Excluded productions include those for which a Canadian is not the owner of worldwide copyright for the first 25 years following completion. This reference to copyright may permit the CRA to disallow content tax credits where it is of the view that an investor has received a beneficial interest in copy-right, notwithstanding the efforts of Finance to clarify the rules.

Industry participants regret that the uncertainty still exists but are optimistic that Finance will continue its efforts to permit private investment in Canadian content productions by reviewing the role of copyright ownership in Canadian content generally.

TELEFILM CANADA AND CAA

In the spring of 2004, Telefilm Canada, the Canadian federal agency charged with fostering the production of Canadian-content films, took the bold step of setting up a pilot project with Creative Artists Agency ("CAA"), the Beverly Hills power-house. The goals of the CAA project are twofold: first, to repatriate Canadian talent resident abroad; and second, to help Canadian producers attach talent to, find financing for and distribute their films. In exchange for CAA's services, the Canadian producer will pay CAA a fee of up to 1% of the production budget, depending on the services rendered. It is hoped that by tapping into the resources of an agency like CAA, Canadian producers will be able to create Canadian content productions with box office appeal. It is too early to evaluate the success of the pilot project, which runs to the spring of 2005, but industry participants will be watching its effect on box office numbers very closely.

CONTINUED IMPORTANCE OF SOFT MONEY

Since distributors and broadcasters remain reluctant to make significant pre-sale advances or commitments, producers must fund the resulting deficits from other sources. As in previous years, the most attractive source of funds to complete financing has been "soft money," funds that are generated by means other than sales of product (e.g., tax credits, sale-lease-back, equity funds). These incentives can be described in two general categories: direct incentives, such as wage credits, sales tax rebates and reductions or waivers of capital tax, and indirect incentives, which are designed to promote private investments, such as accelerated or preferential depreciation allowances. However you choose to describe it, this "soft money" continues to be an important supplement to more traditional commercial funding sources such as distribution advances, minimum guarantees and broadcast license fees.

The year 2004 has seen a continued proliferation in soft money incentives in jurisdictions outside of Canada. These new sources include the introduction of a 20% tax rebate in Hungary, an increasing number of U.S. states providing tax incentives and, of particular concern, the proposed legislation introduced by the U.S. federal government aimed at reducing so-called "runaway" production.

It may be surprising to outside observers, but the increased availability of soft money sources has failed to provide a spark to the industry in Canada. Canadian producers of "content" productions have, in many cases, been hampered or prevented from accessing new sources of soft money in various parts of the world as a result of restrictions applicable to their productions. It should be noted that the scope, relevance and value of these restrictions are increasingly questioned by industry participants. Meanwhile, Canadian producers relying on foreign-originated productions have not seen an increase in their business due to factors ranging from the continued popularity of reality programming to the fierce competition for location shooting. Industry stakeholders have voiced concern that if production levels continue to decline, Canada faces the erosion of its film and television industry infrastructure, which has taken decades to build.

DIFFICULTIES IN USING SOFT MONEY

Canadian producers have no choice but to attempt to access whatever soft money they can, from wherever they can. The results, as evidenced by transactions we have been involved with, are financing structures that are complicated and fragile patchworks of soft money sources, sales and producer deferrals (lots of deferrals!). In today's environment, there is simply no such thing as a simple production financing—the days of a financing consisting of two or three sources are long, long gone.

Each production is made up of hundreds of elements, many of which are moving targets until the day that production actually starts. In many cases, the "strings" associated with soft money can be an unwanted distraction to the people working on a film. Producers now spend less time producing than they do dealing with accountants, lawyers and government bureaucrats across several time zones. This allocation of energy can have severe consequences for the production.

In early 2004, a situation developed that illustrated the fragile position of producers who must, as a result of market conditions, maximize their access to soft money sources. On February 10, 2004, the U.K. Department of Inland Revenue ("Inland Revenue") announced that it would be disallowing expenses claimed by certain limited partnerships investing in film—effectively shutting down the operation of such partner-ships. These controversial partnerships had, until the announcement date, been providing tax deferrals for their investors while providing producers up to 35% of a qualifying film's budget. Inland Revenue took the position that their announcement should not have taken anyone by surprise, but the result was the immediate shelving or shutting down of numerous projects that had relied on the financing contribution from the partnerships and could not replace it on short notice.

The effect of Inland Revenue's move was felt as far away as Canada, where the producers of a Canada-U.K. treaty co-production entitled The River King were left with a picture already in preproduction and a shortfall of 30% of the film's budget. The domino effect caused by taking away such a significant amount of money was immediate and devastating to the film. If the film were not financed as planned, its status as an official Anglo-Canadian treaty co-production could be at risk, with the resulting loss of additional financing dependant on the co-production status, thereby creating an even bigger deficit. The production was shut down for several weeks as the producers attempted to restructure and revive the film, which they ultimately did after many, many hours of hard work, all under the threat of shutting down the film completely. What happened with The River King illustrates the difficulties associated with producing in today's environment, where the focus shifts from filmmaking to complying with the myriad of rules and regulations required to access funding. Additionally, it points to the potential hazards of relying on aggressive soft money schemes that may lose favour with governments in an untimely fashion.

IMPEDIMENTS TO COMBINING INCENTIVES

Despite the continued importance of soft money financing, Canadian content producers often have to choose between maximizing Canadian incentives and accessing soft money financing, since these financing sources are, in some cases, incompatible. So, at a time when soft money financing is abundant, Canadian producers are unable to enjoy full access, especially in the U.S., the U.K. and Germany.

U.S. Incentives The treaty co-production system was originally developed to allow foreign producers to compete with U.S. productions. As a result, there is no co-production treaty between Canada and its largest production partner, the U.S. The CRTC's "co-venture" regime does permit certain co-productions between Canadian and U.S. partners to qualify as Canadian content for broadcast purposes, but such co-ventures do not usually qualify as Canadian content for the purposes of tax credits or other incentives, such as funding from the Canadian Television Fund or Telefilm Canada.

The effect is that Canadian producers often have to choose between producing without a U.S. partner, which may permit access to Canadian content incentives but eliminates access to U.S. incentives, and acting as a production services provider for a U.S. producer, which may permit access to U.S. incentives but eliminates access to Canadian content incentives. Given the recent rise of incentives in the U.S., some industry participants have suggested that it may be time to consider an intermediate position, such as a tax credit for Canada-U.S. co-ventures, perhaps at a rate less than the content credit, but greater than the services credit.

U.K. Incentives.  For the past several years, the U.K. has been a major source of soft money financing. U.K. sale-lease-back providers and U.K. equity funds have targeted producers around the world, including Canada, as potential beneficiaries of their financing. As noted above, Canadian producers found a way to combine these U.K. incentives with their own Canadian incentives, thereby greatly increasing the soft money financing in their budgets. Unfortunately, things that seem too good to be true often are: The U.K. government announced changes to its co-production rules that may prohibit Canadians from accessing U.K. sources of soft money financing. In 2003, the U.K. Department of Media, Culture and Sport announced that as of January 5, 2004, the minimum U.K. participation in Anglo-Canadian co-productions would be 40%, as opposed to the 20% minimum set out in the Canada-U.K. co-production treaty. Since most Canadian incentives are based on the level of Canadian expenditures, the increased U.K. expenditure requirement would reduce the amount of Canadian incentives available, making the U.K. a less attractive destination for Canadian producers. As a result, soft money sources in the U.K. have become less accessible to most Canadian producers.

German Incentives. German net-benefit and equity funds are an attractive source of soft money financing, both for producers and German investors. Although there is a co-production treaty between Canada and Germany, few of these German funds are willing to finance Canada-Germany co-productions because the treaty rules require copyright in such productions to be owned by both co-producers. Since the tax deduction sought by the investors in these German funds is predicated on copyright ownership, the shared ownership required by the treaty rules would result in the tax benefit to the investors being reduced or disallowed. As a result, Canadian producers are unable to combine their Canadian incentives with German soft money financing.

THE COPYRIGHT CONUNDRUM

Copyright ownership is central to most Canadian content incentives, including the treaty co-production rules administered by Telefilm Canada. Most soft money financing structures, however, require the financiers to own or control copy-right at some point during the production process. The challenge for Canadian producers is to persuade the regulatory authorities, including CAVCO, Telefilm Canada, the CRA, which administers various tax credit programs, and their provincial equivalents that disposition of a limited interest in copyright to a soft money financier should not disqualify a production from being considered Canadian content. For example, U.S. studios, which are extremely sophisticated and very sensitive to issues of piracy, have successfully accessed the German and U.K. equity funds by distinguishing between bare copyright, which is retained by the equity fund, and the more economically valuable distribution rights, which are retained by the studios.

Which approach is correct: the view that says bare copy-right can be bartered for cash without changing the fundamental nature of the subject production, or the opposing view that holds that even bare copyright cannot be disposed of by the producer? It is our view that the latter position is out of date and only serves to handcuff an otherwise entrepreneurial industry. We believe that serious consideration by the Canadian authorities on the role played by copyright is merited, especially in light of the current economic factors affecting this industry.

MORE COMPETITION FOR CANADA

While soft money has implications on Canadian producers structuring transactions, the incentive also plays a very important role in determining which productions—primarily U.S.—choose Canada as a location. The declining levels of production in Canada are attributable to a variety of factors, but four key factors have been the topic of discussion of many industry observers. First, growing concern in the U.S. about "off-shoring" jobs politicized the U.S. fear of "runaway" production, which has led to a concerted effort to keep U.S. productions at home. Second, the growing strength of the Canadian dollar relative to the U.S. dollar and other foreign currencies has made Canada less attractive to foreign producers. Third, the increased number of countries competing to attract the same number of productions through the use of tax or other incentives. Fourth, the continuing popularity of reality television has meant fewer productions leaving the U.S. -our largest source of foreign originated production.

To make matters worse, in October 2004 the U.S. Congress passed a legislation known as the American Jobs Creation Act. Next stop for the legislation is the White House, where it will likely be signed into law. In this bill, Congress has taken aim at so-called "runaway" production and proposed measures that they hope will encourage certain film and television producers to shoot their productions in the U.S. While the final language of the legislation may include some additional points, this is what we know so far: (i) instead of using the current income forecast method for amortizing the costs of films, the cost of qualifying productions would be permitted to be immediately written off in the year the expenditure occurs, which is similar to the tax treatment motivating the vast investment by German media funds in Hollywood; (ii) at least 75% of the cost of the production must be for services performed in the U.S.; and (iii) the proposed legislation would apply only to qualifying film or television productions that do not exceed US$15 million in costs (US$20 million in certain designated areas).

In creating this legislation, U.S. lawmakers have borrowed heavily from the successes of countries like Australia, the U.K. and Canada in attracting foreign production and have focused their sights on the type of productions most likely to benefit from shooting in a foreign location. Whether this legislation and the tax incentives offered by all but nine U.S. states has the impact hoped for remains to be seen. However, it is clear that the U.S. has chosen the path of encouraging private investment in its film and television industry in combination with the existing public incentives—similar to the situation in Canada prior to 2001.

CURRENCY EXCHANGE RATES

Canadian producers and production service providers have often extolled two key virtues of Canadian locations to their U.S. neighbours: geographical proximity and favourable exchange rates. The rise of U.S. production in more distant countries such as Australia, New Zealand and South Africa has demonstrated, however, that while geographic convenience is a factor, financial considerations are just as important in location selection. By November 2004, the Canadian dollar had exceeded US$0.82, an exchange rate not seen since 1993 and considerably higher than the rates of US$0.64 to US$0.68 experienced between 1998 and 2002, a period during which foreign production in Canada experienced significant and sustained growth. Of course, the exchange rate between Canada and the U.S. is rarely the determinative factor in choosing a Canadian location, but it can tip the balance amount toward similarly situated options. If the Canadian dollar retains its cur-rent level, then other elements of the Canadian production location "package" will have to be advocated or adjusted to lure productions back into Canada.