PMG is an international CPA firm with offices in many countries around the world. When they say there is a benefit to American taxpayers in the AJCA, I think we'd better listen. KPMG is just one of a number of CPA firms that have reviewed the American Jobs Creation Act and have recommended it for their clients. The CPA firm has not, however, endorsed the projects described in our website, nor has the firm reviewed any of our Private Placement Memorandums of the legal or tax opinions set forth in them.

We have included below a KPMG analysis of the application of the American Jobs Creation Act to various tax situations. It is reproduced from Film Financing and Television Programming: A Taxation Guide (3rd Edition) by KPMG (cover image at right).

You might want to print it and give it to your tax lawyer or CPA, or go to our Downloads Page to download a brochure in PDF format based on this information. You will need the free Adobe Acrobat Reader to view the file.

Note: This analysis is quite lengthy and covers many aspects of motion picture financing that may not be of interest to investors in our film partnerships. To go directly to the section below that deals with the AJCA, click here.

Film Financing

Financing Structures

Co-production

A U.S. resident investor may enter into a joint arrangement with a foreign investor to finance and produce a film in the U.S. Under a co-production structure, each investor contributes funds to the project commensurate with their anticipated benefits from the exploitation of the film. The rights to exploit the film may be allocated to the partners according to their respective territories, with the remaining territories being divided or held jointly among the parties according to mutual agreement.

Where the investors contribute funds to, and share in the profits of, the project, the co-production will likely be characterized as a partnership for U.S. tax purposes. Generally, a partnership itself is not subject to federal income tax. Certain state and municipalities, however, may levy a tax on the partnership. For example, California levies an annual tax of US$800 on limited partnerships. The discussion below regarding partnerships and the taxation of partners will apply where the co-production is characterized as a partnership.

A significant concern in a co-production that is characterized as a partnership is whether the foreign investor is considered to be engaged in a trade or business in the U.S. A partner in a partnership that is engaged in a trade or business in the U.S. will be deemed to be engaged in a U.S. trade or business. If the foreign investor is resident in a treaty country, the co-production must be engaged in a trade or business through a permanent establishment before the venture’s income will be subject to U.S. income taxation. If a permanent establishment is found to exist in the U.S., it is then necessary to determine the amount of income that should be attributed to the permanent establishment and, thus, subject to U.S. federal income tax. If structured correctly, the partnership may report a net income equal to a small percentage mark-up on its expenditures, a so-called cost-plus arrangement. The foreign investors will be subject to U.S. tax on their respective share of the partnership profits. Additionally, in the absence of a treaty exemption, foreign corporate investors may be subject to a branch profits tax and branch tax on interest at a rate of 30 percent.

Under certain circumstances, the co-production may not constitute a partnership for U.S. tax purposes. If the co-production is conducted by investing through a U.S. corporation for tax purposes, the corporation itself will be subject to federal income tax, and the investors subject to tax on dividends received (subject to treaty relief for foreign investors) from the U.S. corporation. If the co-production is conducted by investing through a foreign corporation, U.S. investors must be concerned with an assortment of U.S. tax provisions, including, for example, the subpart F rules and the passive foreign investment company rules, which prevent U.S. taxpayers from sheltering income offshore through foreign corporations. The co-production also may be treated as a loan; however, such treatment is unlikely if the investors share in the profits from the exploitation of the film in exchange for their contribution of funds to the project.

Furthermore, the co-production may be structured as a “qualified cost-sharing arrangement.” Under such an arrangement, the co-production will not be treated as a partnership for U.S. tax purposes, and any foreign investor will not be treated as engaged in a U.S. trade or business solely by reason of its participation in the co-production. Under a cost-sharing arrangement, the U.S. and foreign investors split the production cost in proportion to their reasonably anticipated benefits from the film rights assigned to them. A cost-sharing arrangement is considered a qualified cost-sharing arrangement only if it meets the requirements set forth in Treasury Regulation Section 1.482-7.

Assuming the U.S. investor retains only the U.S. distribution rights, the U.S. resident investor will be subject to U.S. federal income tax on profits arising from the exploitation of the film in the U.S. Special depreciation rules (see “Amortization of Expenditure” below) are allowed to offset the revenues derived from the film’s distribution. Assuming the foreign investor retains only non-U.S. distribution rights and has no U.S. trade or business other than the co-production (if structured as a qualified cost-sharing arrangement, the co-production will not be treated as a U.S. trade or business of the foreign investor), the foreign investor should not be subject to U.S. federal income tax upon distribution of the film outside the U.S. However, caution should be exercised in structuring any arrangement to ensure that the foreign investor avoids U.S. taxation on distribution income.

The following are examples of relief available under selected treaties:

Partnership

Financial investors from several territories and film producers may become limited and general partners, respectively, in a U.S. partnership, with the film being distributed by independent distributors for a fee. Each partner under this arrangement contributes funds to the partnership in return for a share of the partnership profits; the partners will have acquired a capital interest in the partnership assets generally equal to the amount of capital contributed by them. The partnership may receive royalty proceeds under distribution agreements from both treaty and non-treaty countries and proceeds from the sale of any rights remaining after exploitation. These combined proceeds are first used to repay the limited partners before any other distributions are made.

Sometimes a partner in a partnership will contribute a promise to perform services in the future instead of property. If by reason of the promise, the partner is allocated a portion of the partnership capital, the partner will recognize income in an amount equal to the capital allocated, and the partner will have a basis in the partnership for the same amount. If, on the other hand, the partner receives an interest in the partnership profits only, the partner will generally not recognize any income and the partner will not have any basis in the partnership, except to the extent that in the future the partnership has undistributed profits.

Generally, a partnership itself is not subject to federal income tax. The partners in the partnership are taxed on their distributive share of the partnership’s profits and losses. Partnership profits and losses may be allocated by the partnership agreement, but such allocations must reflect the economic substance of the partnership arrangement. Complex laws determine the amount of partnership losses that are deductible in a taxable year, but generally these losses cannot exceed a partner’s capital account plus third-party loans to the partnership for which the partner is at risk (i.e., the amount the partner is personally liable to pay the creditors of the partnership). Such partnership profits or losses are passed up to the partners, whether resident or non-resident, and are added to the partner’s other U.S. taxable income or losses for the year, and tax is calculated on this base. A U.S. partner’s tax base for the purposes of calculating tax includes its worldwide income. A non-resident partner’s taxable base, however, includes only income that is “effectively connected” with a U.S. trade or business and certain U.S. source income.

Effectively connected income includes the non-resident partner’s share of partnership income or losses. U.S. tax law requires that if any partnership, whether foreign or domestic, has effectively connected income that is allocable to a foreign partner, the partnership must withhold federal taxes on behalf of the foreign partners. The amount of withholding is the “applicable percentage” of the effectively connected income of the partnership that is allocable to the foreign partners. The applicable percentage is the highest U.S. marginal tax rate for the partner, and is dependent on the tax status (i.e., individual or corporation) of the partner. Relief from the withholding tax may be available under certain tax treaties. Certain states, such as California, also impose a similar withholding requirement on foreign partners; treaty relief is not available for this tax.

Limited Liability Company

The joint venture may also take the form of a limited liability company (“LLC”). Although the body of law surrounding LLCs is not as developed as corporate or partnership law, the LLC has quickly become the entity of choice in many industries due to its partnership-type flexibility with regard to distributions and its corporate-type liability shield. An LLC is a hybrid entity that provides limited liability to its members while being treated as a partnership for federal income tax purposes and most state income tax statutes. For federal income tax purposes, the LLC itself generally is not considered a taxable entity (although it is possible to elect to have the LLC treated as an entity taxable as a corporation), but rather the LLC members are taxed as partners on their share of the LLC’s income. Since the LLC is generally treated as a partnership and its members treated as partners for tax purposes, the preceding discussion regarding partnerships applies to LLCs as well.

Yield Adjusted Debt

A film production company may finance its films using loans obtained from financial institutions or other third parties. The loans may be secured by pre-sale contracts with respect to the film or by the general assets of the production company.

A film production company may sometimes issue a “debt security” to investors with its yield linked to revenues from specific films. The principal would be repaid on maturity and there may be a low (or even nil) rate of interest stated on the debt instrument. However, at each interest payment date, a supplemental (and perhaps increasing) interest payment would be paid where a pre-determined target is reached or exceeded (such as revenues or net cash proceeds).

For U.S. tax purposes, this “debt security” might be characterized as equity in the form of preferred stock, because the payment of “interest” is dependent on the profitability of specific films. Consequently, payments of “interest” would be recharacterized as dividend distributions taxable to the recipient to the extent of the corporation’s earnings and profits. Such distributions are not deductible in determining the corporation’s taxable income for the year. When the “debt” is repaid, there would generally be no tax consequences because the transaction would be characterized as a return of capital.

However, if the “debt security” carries an interest rate that closely approximates a fair market rate in addition to a contingent portion, it would be more akin to a true debt instrument. In this case, the interest would likely be deductible to the production company (subject to various limitations imposed on domestic and international financing transactions such as the earnings stripping rules, the applicable high-yield discount obligations rules, etc.).

Regardless of the characterization of a distribution as dividend or interest, if the distribution is made to a foreign person, withholding tax will be levied on the distribution, but treaty relief may be available.

Equity Tracking Shares

These shares provide for dividend returns dependent on the profitability of a film production company’s business. These shares typically have the same voting rights as the production company’s ordinary (i.e., common) shares except that dividends are profit-linked and have preferential rights to assets on liquidation of the company.

If the production company is a U.S. corporation, dividends on such stock would generally be treated in the same manner as dividends on ordinary shares.

If the tracking shares are acquired by a U.S. investor and the production company is incorporated outside of the U.S., any tracking dividends received would be included as income to the U.S. investor in the same manner as dividends received on ordinary shares. Generally, a direct foreign tax credit is allowed for withholding taxes paid on the dividend, and “deemed paid” foreign tax credits may be allowed to a 10 percent or greater U.S. corporate shareholder for the amount of tax paid by the foreign corporation which is related to the income out of which the dividend is paid. Also, any tax withheld at source may be mitigated according to the dividend article of the appropriate tax treaty.

Tax and Financial Incentives

Federal incentives

The American Jobs Creation Act of 2004 (the “Act”) was enacted on October 22, 2004, and provides for federal tax incentives applicable to the film and television industry in the U.S.

The Act permits U.S. taxpayers to elect, for any “qualifying film and television productions,” to immediately expense certain production expenditures up to $15 million ($20 million if incurred in certain low-income or distressed areas), in lieu of capitalizing the cost and recovering it through depreciation. “Qualified film or television production,” means any production of a motion picture film or videotape if 75 percent of the total compensation is for services performed in the U.S. by actors, directors, producers, and other relevant production personnel. The term “compensation” does not include participations and residuals. For purposes of a television series, only the first 44 episodes of the series are taken into account. This provision is effective for qualified productions commencing after October 22, 2004 and before January 1, 2009.

The Act repeals the extraterritorial income exclusion (“EIE”), under which U.S. film producers and distributors could deduct a portion of the revenues generated from the sale or license of qualifying films or television programs for exploitation outside the U.S. However, for transactions during 2005, taxpayers may still claim 80 percent of the EIE benefit available, and, for transactions during 2006, taxpayers may still claim 60 percent of the EIE benefit available. Additionally, EIE remains in full effect for transactions entered into in the ordinary course of business that are pursuant to a binding contract between the taxpayer and an unrelated person if such contract is in effect on September 17, 2003, and at all times thereafter.

The film and television industry is further benefited by the “qualified production activities” deduction provided by the Act. When fully phased-in, the Act will provide a deduction in an amount equal to 9 percent of the “qualified production activities income” earned by a taxpayer for the taxable year. “Qualified production activities income” is equal to “domestic production gross receipts” reduced by the sum of (1) allocable cost of goods sold, (2) other directly allocable deductions, and (3) a proper share of other deductions that are not directly allocable to such receipts.

“Domestic production gross receipts” includes any lease, rental, license, sale, exchange, or other disposition to an unrelated person of a “qualified film” produced by the taxpayer. “Qualified film” includes any motion picture film, videotape, or television program if 50 percent or more of the total compensation relating to the production of such property (including participations and residuals) constitutes services performed in the U.S. by actors, production personnel, directors and producers.

For taxable years beginning after 2009, the “qualified production activities” deduction is equal to 9 percent of the lesser of (1) the qualified production activities income of the taxpayer for the taxable year or (2) taxable income (determined without regard to this provision, and after calculation of the net operating loss deduction) for the taxable year. For taxable years beginning in 2005 and 2006, the deduction is 3 percent of such income and, for taxable years beginning in 2007, 2008 and 2009, the deduction is 6 percent of such income. However, the deduction for a taxable year is limited to 50 percent of the wages paid by the taxpayer (or its agent) to employees of the taxpayer during the calendar year that ends in such taxable year.

State Incentives

Approximately 30 states offer tax or financial incentives, most notably Hawaii, Louisiana, New Mexico, and New York.

Hawaii offers two tax incentives for film and television productions.

·         First, a refundable production tax credit, which offers a 4 percent credit on the total production expenditures incurred in Hawaii, including purchases and payroll, and a 7.25 percent credit on its transient accommodation tax. The taxpayer will receive either 100 or 75 percent of the credits provided the project adheres to certain production and distribution criteria.

·         Second, a non-refundable 100 percent investment tax credit, claimed over a five-year period, is applicable to investors in “qualified high technology businesses” (“QHTB”), which includes film and television. The maximum amount of investment qualifying for the credit is $2 million annually, per investor, per QHTB.

Louisiana offers three incentive programs.

·         First, an investment tax credit can be claimed for investing in productions in the state. If the investment is greater than $300,000 and less or equal to $8 million, each taxpayer is entitled to a tax credit of 10 percent of the actual investment made by that taxpayer. If the investment is greater than $8 million, the tax credit is 15 percent.

·         Second, an employment tax credit of 10 percent of the total aggregate payroll for state residents employed in connection with the production when total production costs in Louisiana equal or exceed $300,000 but are less than $1 million during the taxable year. The employment tax credit is 20 percent when total production costs equal or exceed $1 million during the taxable year.

·         Third, a production company that reports anticipated expenditures of $250,000 or more from a checking account in the state in connection with the production of one or more motion pictures within a consecutive twelve month period in the state can receive a 4 percent sales tax exemption.

New Mexico offers four incentive programs.

·         First, a film production tax rebate of up to 20 percent of the total production costs incurred in New Mexico.

·         Second, a production company can receive a gross receipts tax (i.e., sales tax) exemption at point of purchase by presenting the vendor with a “nontaxable transaction certificate.” Production companies intending to take the film production tax rebate may not use the gross receipts tax exemption.

·         Third, New Mexico offers interest-free production loans capped at $15 million provided certain criteria are met.

·         Fourth, New Mexico offers a 50 percent wage reimbursement to production companies that hire and provide on-the-job training for upgrading crew members and new trainees. In addition, new legislation provides for a loan of up to 80 percent of the estimated tax rebate, effective July 1, 2005.

New York offers a refundable production tax credit equal to 10 percent of the qualified production costs incurred for a qualified film or television production. In order to qualify, the production must incur at least 75 percent of its qualified production costs (excluding post-production costs) at a qualified production facility in New York. If such costs are less than $3 million, the production must shoot at least 75 percent of its location days in New York to qualify; if not, the credit is available only for qualified production costs incurred at the qualified production facility. “Qualified production costs” generally means below-the-line costs incurred in the production (including pre-production and post-production) of the qualified film or television production. Additionally, New York City (“NYC”) recently enacted the “Made in New York Incentive Program,” which includes a 5 percent refundable production tax credit, and a marketing credit for outdoor media valued at 1 percent of NYC production costs, for qualified film and television productions that are at least 75 percent completed in NYC. There is a $25 million cap on the state incentive for each calendar year, and a $12.5 million cap on the NYC incentive.

Other Financing Considerations

Exchange Controls and Regulatory Rules

The U.S. does not have any exchange control regulations.

Corporate Taxation

Recognition of Income

Production fee income

U.S. Resident Production Company

A special purpose company may be set up in the U.S. for the limited purpose of producing a film, video, or television program, without acquiring any rights in the product (i.e., a “work for hire” company). Such a special purpose company would be required to disclose transactions with its foreign related parties. Consequently, the Internal Revenue Service (“IPS”), the U.S. taxing authority, would be notified of income received from a foreign related party and would be able to scrutinize the allocation or attribution of income to the special purpose company.

The IRS would require that the income attributed to the special purpose company be equal to the amount that would have been paid or charged for “the same or similar services in independent transactions with or between unrelated parties under similar circumstances” -the so-called arm’s length standard.

It is possible to obtain an Advance Pricing Agreement (“APA”), which is an advance determination of the amount or percentage of income to be attributed to the special purpose company. However, the APA process is costly and time-consuming and is probably impractical for a “work for hire” company organized to produce a single film project.

Non-U.S. resident production company with an office in the U.S.

If a company is not resident in the U.S., but has a production office to administer location shooting in the U.S., then whether the company’s income is subject to U.S. federal income tax depends on the existence of a controlling income tax treaty and the nature and duration of the company’s U.S.-based activities.

If there is no controlling treaty, the company will be subject to U.S. federal income tax if the company’s employees or agents engage in regular and continuous activity over and above mere administrative activities. Operating a production office to oversee the U.S. location shooting appears to meet this level of activity, and the office would be subject to tax because the company would be treated as having a U.S. trade or business.

If no treaty controls and the company were treated as having a U.S. trade or business, the company would be subject to tax on:

•  gross U.S. source fixed or determinable, annual or periodic income at the rate of 30 percent

•  net U.S. source income that is effectively connected to the U.S. trade or business

•  certain types of the company’s foreign-source income to the extent effectively connected to the U.S. trade or business.

If a controlling treaty exists, the concept of a permanent establishment subjects the production office to U.S. taxation roughly based on the type of facility and level of U.S. presence attributable to the office. If the office operates in the U.S. for a short ; amount of time, permanent establishment characterization is essentially a facts and ! circumstances analysis. If the presence continues for a relatively long period of time, it generally constitutes a permanent establishment. Assuming that a treaty : does control and the office does not constitute a permanent establishment, the : treaty would prevent the IRS from taxing the business profits of the office.

If a treaty did control and the office did constitute a permanent establishment, the ; business profits related to the office would be chargeable to tax, to the extent that ! they were attributable to the permanent establishment. Additionally, the IRS would j be able to scrutinize the level of profits of the “permanent establishment” office and 1 attribute to the office the “profits which it might be expected to make if it were a i distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently” with respect to   transactions with its foreign related parties.

Non-U.S. resident production company without an office in the U.S.

If no treaty controls, a non-resident company that does not maintain a production office but undertakes location shooting in the U.S. may be chargeable to tax in the U.S. as having a U.S. trade or business.

If no treaty controls and the company were treated as having a U.S. trade or business, the company would be subject to tax on:

·         gross U.S. source fixed or determinable, annual or periodic income at the rate of 30 percent

·         net U.S. source income that is effectively connected to the U.S. trade or business

·         certain types of foreign-source income to the extent the income is effectively connected to the U.S. trade or business.

If a treaty does control and the company undertakes location shooting in the U.S. for less than six months, the company’s presence in the U.S. most likely would not constitute a permanent establishment, and the company would not be chargeable to tax as long as it lacks permanence. Conducting location shooting in the U.S. for a period longer than six months may constitute a permanent establishment, depending on the specific facts and circumstances. However, if the film takes less than twelve months to shoot in the U.S., the company’s location still may not constitute a permanent establishment by analogy to the treatment of construction projects completed in less than a year, which are not considered permanent establishments under most U.S. treaties.

If a treaty controls and the location shooting in the U.S. constitutes a permanent establishment, the business profits of the company would be chargeable to tax, to the extent that they were attributable to the permanent establishment.

Transfer of distribution rights

A transfer of all or substantially all copyright rights to exploit or distribute a film or television program within a specified geographic area for the remaining life of the copyright will be treated as a sale of an intangible property right under U.S. law. However, if the intangible is sold in exchange for a stream of contingent payments (e.g., based on revenues), the contingent payments will be taxed in a manner similar to that of a license of the copyright. The following factors are important in determining whether a transfer will be treated as a sale or a license: whether all or part of the rights to the film or television program are transferred; whether key rights have been reserved by the transferor; whether the transfer covers specific geographic regions; whether the transfer is exclusive or nonexclusive, and whether the rights are transferred for the remaining life of the copyright.

Certain tax treaties provide their own definition of royalties and business profits with respect to intangible property transfers regardless of the classification of a transaction as a sale or a license under domestic tax law.

Some tax rules that govern the transfer of intangible assets offshore are as follows:

·         transfer pricing rules related to transfers of intangibles for other than arm’s length consideration can apply retroactively to adjust the sales price

·         when an intangible is transferred offshore, if the recipient (or holder) of the roy­alty is not resident in the same country as the beneficial owner of the intangible, the reduced withholding rates of the treaty may not apply.

U.S. resident production company- transfer of distribution rights Generally, distribution rights should be transferred from the U.S. by either a sale or a license. Whether a sale or a license is a more favorable means of transferring distribution rights depends on the specific provisions of the applicable treaty.

Distribution rights cannot be transferred outside of the U.S. to a foreign corporation through a non-taxable transfer (i.e., corporate organization or reorganization); instead, the U.S. transferor is deemed to have sold the rights to the foreign corporation in exchange for a royalty that may be retroactively adjusted by the IPS so the royalty clearly reflects the proper income of the U.S. taxpayer. However, it may be possible to transfer the distribution rights tax-free to a foreign partnership.

U.S. resident distribution company - acquisition of distribution rights

The timing of the deduction of the payments for tax purposes depends on whether the distribution rights are purchased or licensed and on whether the transferee is a cash or accrual method taxpayer.

Whether the acquisition of the distribution rights is treated as a purchase or license, both cash and accrual method taxpayers must capitalize the payments for the distribution rights. The acquisition costs, then, may be depreciated by one of two methods: the straight-line method (which allows equal amounts of depreciation over the useful life of the intangible right or over a 15-year period if the rights are acquired in connection with the acquisition, of a trade or business or substantial portion thereof) or the income-forecast method (which allows as depreciation a percentage of capitalized distribution costs equal to the year’s actual revenues divided by the total projected revenues). See discussion below regarding “Amortization of Expenditure’.’

For contingent royalty payments, whether paid under a purchase or license of a film, the timing of the deduction of payments made depends on whether the company uses the cash or accrual method. Generally, the cash method company may deduct payments when paid.

Conversely, the accrual method company will be able to deduct only that portion of the license payment that relates to the current tax year.

If the payments constitute advances, the federal tax rules suggest that the payments should be amortized over the term of the license using the straight-line method. However, industry practice has been to amortize the payments over the term of the license using the income forecast method because it provides for much closer matching of deductions with income. An argument also exists for amortizing the payment over the term of the recoupment of the advance.

The type of income arising from exploiting rights in a given country depends on the applicable treaty and the characterization of the acquisition of such rights as either a purchase or a license. Certain treaties characterize income from either the purchase (including contingent payments) or the license of films rights as royalties. Under other treaties, all payments from either a sale or a license of the use or right to use cinematographic films or films used for television broadcasting are excluded from the definition of “royalties” and instead are treated as trading income (business profits).

Non-U.S. resident company

If the company is resident in a non-treaty country, the analysis is the same. The income from exploiting the distribution rights will likely be treated as royalty income or capital gain, depending on the specific facts involved.

Transfer of distribution rights between related parties

Where a worldwide group of companies holds rights to films and videos, and grants sublicenses for the exploitation of those rights to a U.S. resident company, care needs to be taken to ensure that the level of profit can be justified. Upon examination, the IRS will query the level of profit earned by the U.S. sublicensee by examining the payments made to related foreign companies. Generally, the amount of the license fee must be commensurate with an arm’s length exchange as discussed above.

Substantial tax penalties may be assessed if it is later determined that the exchange between related parties was not at arm’s length. However, the penalty provisions provide an escape clause for taxpayers who in good faith attempt to ascertain the arm’s length charge and contemporaneously document their transfer pricing methodology.

Amortization of Expenditure

Treatment of production costs

A film producer who retains film rights may incur substantial costs over a period of several years in connection with the production of a film. Two methods are available to the film producer for the amortization of the production costs of the film — the income forecast method and the straight-line method. As discussed above, a film producer may elect for any “qualifying film and television productions” for which production commences after October 22, 2004 and before January 1, 2009 to immediately expense up to $15 million ($20 million incurred in certain low-income or distressed areas) of production costs, in lieu of capitalizing the cost and recovering it through amortization.

Income forecast method

Typically, the film and television industry claims amortization deductions for production costs under the “income forecast” method. Under this method, taxpayers determine the amortization deduction for a taxable year by multiplying the capitalized production cost of the property by a fraction, the numerator being the current year income and the denominator being the forecasted total income.

For films and television programs released prior to October 22, 2004, “current year income” means the net income generated by the property in the current taxable year (gross income less distribution costs for such year), and “forecasted total income” equals the sum of the current year income for the year the property is released plus all reasonably estimated net income (gross income less distribution costs) from subsequent years up to and including the tenth taxable year after the year the property is released. For films and television programs released after October 22, 2004, gross income, not net income, from the property is used to calculate current year income and forecasted total income for purposes o’* computing the allowable deduction under the income forecast method.

Determination of income (current year and forecasted total) In the case of films, television programs, and other similar property, income (current year and forecasted total) includes, but is not limited to: income from foreign and domestic theatrical, television and other releases and syndications; income from releases, sales, rentals, and syndications of video tape, DVD, and other media; and income from the financial exploitation of characters, designs, titles, scripts and scores earned from the ultimate sale to, or use by, unrelated third parties. Examples of this third income category include the sales of toy figurines of animated films or television programs, or licensing income from the use of an image.

In the case of a television series produced for distribution on television networks, income (current year and forecasted total) need not include income from syndication of the television series before the earlier of the fourth taxable year beginning after the date the first episode in the series is placed in service, or the earliest taxable year in which the taxpayer has an agreement to syndicate the series.

The forecasted total income from the film or television program for purposes of the income forecast method includes all income expected to be generated by the production for the ten years following the year of release. Any income expected to be earned after this term does not need to be included in the formula. Forecasted total income is based on the conditions known to exist at the end of the tax year for which amortization is being claimed. The rules described in this section also apply to the “look back” method described below.

Revised forecasted total income

Pursuant to proposed regulations issued by the IRS, if information is discovered in a taxable year following the year in which the property is placed in service that indicates that forecasted total income is inaccurate, a taxpayer must revise the forecasted total income. Under the revised computation, the unrecovered depreciable basis of the property is multiplied by a fraction, the numerator of which is the current year income and the denominator of which is obtained by subtracting from revised forecasted total income the amounts of current year income for prior taxable years.

The revised computation must be used in any taxable year following the year in which the income forecast property is placed in service if forecasted total income (or, if applicable, revised forecasted total income) in the immediately preceding taxable year is either less than 90 percent of the revised forecasted total income for the taxable year, or greater than 110 percent of the revised forecasted total income for the taxable year.

Determination and treatment of cost of property

The cost of the property includes only costs that satisfy the economic performance standard of Internal Revenue Code (“IRC”) Section 461 (h). For that purpose, economic performance can occur at different times depending on the facts and circumstances of a transaction. For example, if a taxpayer incurs a non-contingent liability to acquire property, economic performance is deemed to occur when the property is provided to the taxpayer. In addition, the rules of IRC Section 461(h)(3) relating to the recurring item exception apply.

Costs incurred after the property is placed in service are treated as a separate piece of property if:

·         such costs are significant and are expected to give rise to a significant increase in the income from the property that was not included in the total forecasted income, or

·         such costs are incurred more than ten years after the property was originally placed in service.

If costs are incurred more than ten years after the property was originally placed in service and no income is generated, such costs are deducted as incurred. At this time there is no guidance on what constitutes a “significant” cost or increase in income.

Finally, any adjusted basis of the production not recovered by the tenth taxable year after the property was placed in service can be taken as a depreciation deduction in that year. Presumably, this deduction ignores salvage value.

Look-back method

Taxpayers that utilize the income forecast method for amortization of production costs are required to apply the “look-back” method of accounting. The “look-back” method requires a taxpayer to pay or receive interest by recalculating the amortization deduction (and corresponding increase/decrease in tax) using actual rather than estimated total income from the property. It is applicable to any “recomputation year’,’ which is defined as the third and tenth taxable year after the taxable year the property was placed into service. This requirement does not apply when the actual income from the property for each taxable year ending with or before the close of the recomputation years is within 10 percent of the estimated income from the property for such years. For purposes of applying the look-back method, actual income includes income from the disposition of the property.

In applying the “look-back” method, any costs taken into account after the property was placed in service can, if so elected, be taken into account by discounting such cost to its value as of the date the property was placed into service. This discounting is based on the Federal mid-term rate determined under IRC Section 1274(d). The “look-back” method does not apply to property with a total capitalized cost basis of $100,000 or less as of the close of a recomputation year.

Treatment of participations and residuals

For purposes of computing the allowable deduction under the income forecast rnethod, participations and residuals may be included in the adjusted basis of the eligible property beginning in the year such property is placed in service. The provision applies only if such participations and residuals relate to income that would be derived from the property before the close of the tenth taxable year following the year the property was placed in service. Alternatively, the taxpayer may choose, on a property-by-property basis, to exclude participations and residuals from the adjusted basis of such property and deduct such participations and residuals in the taxable year paid.

Straight-line method

Under the straight-line method, depreciation for the year is computed by dividing a film’s production costs over the film’s estimated useful life. A film’s useful life for depreciation purposes has been the subject of controversy. A film based on a contemporary theme may have a shorter useful life than one based on a historical event.

If a film right is acquired as a part of the acquisition of assets constituting a trade or business or substantial portion thereof, the cost of such film right must be amortized over a period of 15 years.

Treatment of pre-production costs of creative properties

The IRS has provided clarification on the treatment by a film producer of costs incurred in acquiring and developing screenplays, scripts, treatments, motion picture production rights to books, plays and other literary works, and other creative properties.

A film producer is generally required to capitalize creative property costs and, unless a film is produced from the creative property, is not permitted to recover those costs through depreciation or amortization deductions. However, a film producer is now permitted to amortize ratably over a 15-year period the costs for creative properties that are not scheduled for production within three years of acquisition.

Additionally, a film producer may not deduct the capitalized costs of acquiring or developing creative properties as a loss under IRC Section 165(a) unless the producer establishes an intention to abandon the property and an affirmative act of abandonment occurs, or identifiable events evidencing a closed and completed transaction establishing worthlessness occur.

Other expenditure

Neither a film distribution company nor a film production company has any special status under U.S. law. Consequently, they are subject to the same rules as any other U.S. company, and are generally allowed to deduct the expenses of running their day-to-day operations to the extent such expenditures are ordinary and necessary and not of a capital nature.

Certain expenditures of U.S. companies can never be deducted. The following are some examples of such non-deductible expenditures: fines, penalties, bribes, certain executive life insurance, a portion of meals and entertainment, country club membership dues, and certain related party losses. In addition, other expenditures cannot be currently deducted, such as capital expenditures, but must be deducted over the time period of their benefit to the company.

Losses

Net operating losses (i.e., losses from operations) may be carried forward for twenty years to offset future income, or may be carried back for two years and offset against prior year’s income, resulting in a refund of tax. Some states also allow the carryforward and carryback of net operating losses.

Losses attributable to the sale of certain assets used in the taxpayer’s trade or business may be currently deducted. Capital losses on investment assets, however, are only deductible to the extent that there are capital gains for the year. An excess capital loss may be carried back three years or forward five years. States generally follow the federal treatment.

Foreign Tax Relief

Foreign tax relief is provided to U.S. taxpayers by allowing such taxpayers a foreign tax credit or foreign tax deduction for foreign taxes paid. Generally, the foreign tax credit provides the greatest relief from double taxation.

If foreign tax is paid directly by a U.S. taxpayer, a direct credit is allowed, but the credit is generally limited to the amount of U.S. tax that would have been paid had the income been earned in the U.S. If a 10 percent or greater U.S. corporate shareholder receives a dividend from a foreign subsidiary, a “deemed paid” credit may be allowed for the amount of income tax paid by the foreign corporation which is related to the income out of which the dividend is being paid.

Indirect Taxation

Value Added Tax (VAT)

The U.S. has no VAT on the sale of goods or services.

Sales/Use Tax

Sales taxes are generally imposed on sales of tangible personal property and selected services. A complementary use tax is imposed on property purchased for storage, use or other consumption in the state if sales tax was not paid on the purchase. Most states allow for an offsetting credit against the use tax for any sales taxes legally imposed and paid.

All states except Alaska, Delaware, Montana, New Hampshire and Oregon impose sales/use taxes. In addition, many local governments impose sales/use taxes. Rates range from 3 to 8.5 percent.

As a general rule, most states impose sales/use tax on the sale or use of production equipment and supplies. Production labor is also taxable in many states. Production companies typically are required to register for sales/use tax purposes in states which filming or production work is performed.

Customs Duties

For 2004 the following customs duty rates applied to the relevant goods imported. These rates are subject to change in 2005.

Personal Taxation

Non-Resident Artists (self-employed)

Income tax implications

The U.S. taxes non-resident artists on their income originating in the U.S. If the artist’s income is “effectively connected” with a U.S. trade or business, the income is subject to the U.S. graduated income tax rates. Effectively connected income includes income earned by a non-resident artist performing or providing services in the U.S. Where the non-resident artist performs services under contract within and outside the U.S. during the taxable year, the compensation received must be allocated on a time basis in order to determine the compensation earned for services performed in the U.S. An exception applies for non-residents present in the U.S. for a period of 90 days or less during the taxable year performing services on behalf of a foreign person and earning less than $3,000 in the aggregate. In addition, treaty relief may be available; however, such treaty may contain an “artists and athletes” clause that overrides the otherwise applicable treaty protection. If the artist earns U.S.-source income other than effectively connected income (i.e., interest, royalties, etc.), the income is subject to withholding at a 30 percent rate, although applicable treaties may reduce this rate.

Resident Artists (self-employed)

Income tax implications

Artists resident in the U.S. generally must pay taxes in the same manner as other U.S. residents. Consequently, the resident artist would be subject to U.S. taxation on worldwide income. Foreign tax relief is provided by allowing U.S. resident taxpayers a foreign tax credit or foreign tax deduction for foreign taxes paid; however, the foreign tax credit is limited to the amount of U.S. tax that would have been paid had the income been earned in the U.S. Under domestic law, residency is determined under the “substantial presence test” or the “lawful permanent residence test” Under the substantial presence test, an artist will be considered a resident of the U.S. if he or she is present in the U.S. for 183 days during a calendar year, or if he or she is present in the U.S. for at least 31 days during the calendar year and a total of 183 days for the current and two preceding calendar years. For purposes of this 183-day requirement, the number of days present in the U.S. is determined by adding the days present in the current year, one-third of the days present in the immediately preceding year and one-sixth of the days present in the second preceding year. Under the lawful permanent residence test, any non-U.S. citizen who is a lawful permanent resident (i.e., a “green card” holder) of the U.S. will be a resident for tax purposes regardless of the time actually spent in the U.S. Many exceptions apply to these rules, and certain tax treaties override the resident definition contained in domestic law.

Loan-out corporations

One possible tax planning alternative for resident artists is the use of a “loan-out” corporation. A loan-out corporation is a corporation formed by the artist with the artist as the corporation’s sole employee. The corporation, represented by the artist, enters into contracts for the employee’s services, and pays the artist a salary. Generally, the corporation neither earns nor loses income because the salary of the artist offsets the corporation’s income.The advantage of using a loan-out corporation is deferral of recognition of income for a year (through the use of staggered tax years of the corporation and the artist), and the circumvention of deduction limitations placed on individuals in the U.S. (for example, medical expenses). It should be noted that the IRS has vigorously attacked loan-out corporations in the past. However, the IRS currently is not challenging the use of loan-out corporations by artists, and is respecting the loan-out corporation as the employer of the artist for U.S. tax purposes provided the corporate formalities are properly followed and at least one non-tax business purpose exists. Notwithstanding, caution should be exercised when structuring contracts through such an entity.

Employees

Income tax implications

Employers with employees resident in the U.S. are obliged to make regular, periodic payments to both the federal government and, possibly, state and local governments with respect to the employee’s personal tax liabilities arising from wages paid by the employer. An employer makes these payments to the federal and state governments with moneys withheld from the employee’s wages.

The amount of income tax required to be withheld and remitted to the government is generally set forth in tax schedules provided by the government. Salaries and wages include both cash remuneration and generally the value of fringe benefits. However, fringe benefits are non-taxable if they are of a de minimis value.

Social security implications

The social security and Medicare tax is divided equally into employer and employee shares. Employers are required to withhold each employee’s share of social security and Medicare taxes from the employee’s salary and to submit this amount along with the employee’s share to the proper tax authorities. For 2005, social security tax is computed at 6.2 percent for both the employer and employee (12.4 percent total) up to a taxable annual wage base of $90,000. Medicare withholding is computed at 1.45 percent for both the employer and employee (2.9 percent total) with no applicable wage base limitation.

Non-residents working in the U.S. as employees are generally subject to income tax withholding, social security withholding, and Medicare withholding in the same manner as U.S. employees. However, treaty relief may be available.