Please see the handout attached. If it is not available on my profile, please e-mail me at c.l.rinaldi2@gmail.com

1. Tax planning for film production and distribution By Chris Rinaldi

2. TOPICS TO BE COVERED -Film Investment Strategies -State and Local Tax Credits -Federal Tax Benefits of Film Production Film Licensing Strategies -§367(d)/§482 -Tax Treaties/Subpart F

3. FILM PRODUCTION A group of movie producers have found a script which they are excited about. They need to attract investors for the project. They estimate that the total investment needed to produce the film as $2,000,000, including the purchase price of the script. While they would like to attract investors, they are also concerned with maintaining as much ownership rights as possible in the production for themselves.

4. THE FORM OF THE FILM PRODUCTION COMPANY The producers must decide what sort of company they want to form to produce the film. -Corporation vs. LLC -A corporation and LLC both provide limited liability. This is important in a highly speculative venture, such as a movie. The movie has a potential to become insolvent and the producers will want their risk to be limited to what they put into the film, and nothing more. -Tax Aspects -A LLC has more favorable tax features than a corporation in this context. Unlike corporations, LLC’s are taxed as partnerships by default (but can be elected to be taxed as a corporation). This means that they are a pass-through entity, taxed at the individual level of the LLC members. Corporations are subject to a double tax at both the corporate and shareholder level. -Management and Ownership -A LLC also provides more flexibility in structuring the management and ownership of the company. LLCs may define the managers’ duties in the original agreement, and it may have member-managers. This will be useful to designate the producers as. Moreover, the formal requirements of the LLC needed to conduct operations not explicitly mentioned in the agreement can be drafted to be much more fluid than that of a corporation. Film Production Company

5. FEDERAL TAX BENEFITS FOR FILM PRODUCTION Federal tax benefits exist for film production. §§181 and 199 allow deductions for qualified film production costs and returns on investment in a film, respectively. §181 – Qualified Film Production Costs -A qualified production is 1) “Films and video tape. Any motion picture film or video tape” as defined in §168(f)(3), AND 2) 75% of the expenses of the production is qualified compensation. -Qualified compensation is non-contingent labor costs for “actors, production personnel, directors, and producers.” -TAX BENEFIT: If you’re production is under $15,000,000, then all production expenses will be deductible upon the taxpayer’s election. Remember, its all expenses that will be deductible. The “qualified compensation” test is only to see if you are allowed the qualified film production cost deduction. It does not limit the deduction to that compensation. §199 – Deductions for Income Attributable to Domestic Production Activities -A 9% deduction is allowable to a taxpayer on the lesser of their taxable income or qualified production activities income. The deduction cannot exceed 50% of the taxpayer’s employment compensation, either current wages and benefits, or deferred compensation paid to employees. -Qualified Production Activities Income – this is defined as the gross receipts, less expenses allocable to such receipts. -Qualified Film – Income from a film will only qualify if 50% of the production cost is compensation for actors, production personnel, directors, and producers services in the United States. Qualified film includes the copyrights , trademarks, and other IP accompanying the film.

6. STATE TAX BENEFITS FOR FILM PRODUCTION Numerous tax benefits are also available at the state level. Mostly, they come in the form of transferable tax credits. These states are listed below. Louisiana has the most attractive tax credit incentives. A tax credit of 30% is offered on production expenses incurred in Louisiana. A 5% credit is available on the payroll of any Louisiana residents. These credits are fully transferable and, moreover, they can be “cashed-in” with the state for .85 cents on the dollar (85%). -California -25% tax credit for Independent Films (non-refundable) -20% tax credit for Feature Films (non- refundable) -Connecticut -30% tax credit (non-refundable) -Florida -20% tax credit -5% off-season production credit (75% is shot in Florida between 6/1-11/30) -5% family friendly tax credit -*On July 1, 2011, there will be a 90% refund of available credits. -Georgia -20% tax credit (non-refundable) -Sales and Use Tax Exemption -10% tax credit if you include a Georgia state logo in the final production -Massachusetts -20% Payroll Credit (non-refundable) -25% Production Credit (non- refundable) -Sales and Use Tax Exemption -Missouri -35% tax credit (non-refundable; capped at $1,000,000) -West Virginia -27-31% tax credit (non-refundable) -Sales and Use Tax Exemption -Lodging Tax Exemption -Others: -Arizona (10-20%, non-refundable); -Illinois (25%, non-refundable); -Pennsylvania (25%, non-refundable); -Rhode Island (15-25%, non-refundable); -Puerto Rico (numerous benefits in the form of credits and reduced tax rates)

7. FILM PRODUCTION AS A TAX SHELTER Here, Mark and the producers may attract investors with these tax credits, while maintaining their ownership interest in the film itself This film requires a $2,000,000 investment. 30% of $2,000,000 is $600,000, which would be the amount of state tax credits available. Under §181, there will be $2,000,000 of deductible expenses. If Investor A invests $500,000 (1/4 of the budget) the FPC would give them rights in ¼ of the Louisiana State Tax Credits ($150,000). They are only worth 85% if cashed in with the state, equaling $127,500. Therefore, Investor A will only have a $372,500 investment at risk, or a little under 19% investment. Essentially, this transaction can be viewed as two separate ones. But, it is not. Tax Credits Investor A Investor A Interest in the Film Film Production Company Film Production Company Cash Cash

8. FILM PRODUCTION AS A TAX SHELTER Further, Investor A will also be entitled to deduct the entire $500,000 under §181, resulting in a $175,000 tax benefit if the investor is in the 35% marginal tax bracket. Now, his money at risk is reduced to $197,500. Essentially, he receives 60% of his investment back before the film is even completed. When revenues from the film begin to come in they will fall under §199, supposing it is a “qualified film”. This entitles him to a 9% deduction of the income earned from the movie. If he made his money back in the first year ($197,500) from film royalties, .9 cents of each dollar will not be taxed, totaling $17,775. At a 35% tax rate, the investor is saving $6,221.25 on taxes. This serves as a bonus when his investment breaks even.

9. STRUCTURING THE RIGHTS TO THE FILM – 367(d) Next, the FPC and the investors may start a foreign Film Rights Holding Company. This company would hold intellectual property rights tied to the film, such as its distribution and trademark rights. The ownership structure of the FRHC should look identical to the ownership rights in the film (FPC). The FRHC will license out the film rights transferred to sub-licensees, or administer them itself. The creation of the FRHC is nearly identical to a §351 transaction. A §351 transaction is a non-recognition transaction under the code. Property transferors create a corporation and transfer property to the corporation. In return, these transferor's receive stock. They will recognize no gain on the property transferred, nor a loss, granted they meet certain control requirements and the property involved in "qualified" under §351. However, §367(d) negates the application of §351 when the transferee corporation is foreign and the property transferred to such foreign corporation is intellectual property. Instead, the transferor is treated as selling the property to the foreign corporation in return for future payments based upon contingent use, representing an arm's length exchange value, over the property's useful life. ( see §482 on handout). But, the useful life will never be deemed to be longer than 20 years. Film Production Company Investors Producers Film Production Company Film Rights Holding Company Stock Film Rights SELECTED BUNDLE OF RIGHTS FROM FILM

10. THE FILM’S LICENSING ROUTE The FRHC will license the distribution rights to distributors. Generally, the distributor will collect 25% of the gross or net receipts produced through the distribution contracts it enters into. Investors Film Production Company The distribution companies will send the royalty money (75%) to FRHC. This payment, if planned properly, will fall under a tax treaty. The FRHC sends 25% to the producers, which would otherwise be imputed to the producers under §367(d). The FHRC will distribute the royalties it holds, which it would have otherwise, because FRHC is a Controlled Foreign Corporation (CFC). (see handout) Contingent Payment for Transfer of Rights Over Their Useful Life (see 367(d)) 25 % of 75% U.S. Distribution Rights US Film Distributors Film Rights Holding Company 75% of 100% (Royalty) Foreign Film Distributors Foreign Distribution Rights 75% of 100% (Royalty)

11. TREATY SHOPPING In this case, there are two main issues to consider when choosing the jurisdiction of the FRHC. First, we need to determine at what rate the royalties will be taxed as income to FRHC. Even though the royalties arise in the US, they will be taxed in the country where the FHRC is located where tax treaties apply. Most US tax treaties read as follows: “Royalties arising in one of the States and beneficially owned by a resident of the other State shall be taxable only in that other State.” (see US-Netherlands Income Tax Treaty, Article 13) “Royalties arising in a Contracting State and beneficially owned by a resident of the other Contracting State may be taxed only in that other State.” (see US-Ireland Income Tax Treaty, Article 12) “Royalties derived and beneficially owned by a resident of a Contracting State shall be taxable only in that State.” (see US-Switzerland Income Tax Treaty, Article 12) Therefore, the FRHC should be placed in a country with a low corporate income tax rate. Second, we need to determine at what rate distributions from the corporation to its shareholders will be taxed. At some point the producers and investors will want to get their money out of FRHC. The dividend will be taxed at 15% in the US when they receive it. It will also be taxed in the country FRHC is incorporated in, but this tax can be used as a foreign tax credit under §901 to setoff the US tax and avoid double taxation. Although counterintuitive, it may be beneficial for the home country of FRHC to tax the dividend in excess of 15%, but this is rarely allowable under a tax treaty and we want a tax treaty to ensure that the royalty payments received by FRHC will only be subject to tax in FHRC’s country of residence and not in the payor’s country.

12. TREATY SHOPPING DESTINATIONS Under these criteria, there are a handful of countries that would be most beneficial in serving as the home of FRHC. Bulgaria -Royalties paid to and owned by a Bulgarian residents are taxable in the US if they arise their, but at a maximum rate of 5%. (see Article 12, US-Bulgaria Income Tax Treaty) -Dividends may be taxed by both states. But, the tax rate in the Bulgaria cannot exceed 10% on individuals, or 5% on companies owning 10% of the voting stock of the distributing corporation. (see Article 10, US-Bulgarian Income Tax Treaty) Switzerland, Hungary, Ireland, and the Netherlands -Royalties paid to and owned by the foreign resident are only taxable in the foreign country. (see Article 12, US-Switzerland Income Tax Treaty; Article 11, US-Hungary Income Tax Treaty; see Article 11, US-Ireland Income Tax Treaty; see Article 13, US-Netherlands Income Tax Treaty) -Dividends may be taxed by both states. But, the tax rate in these countries cannot exceed 15%, or 5% on companies owning 10% of the voting stock of the distributing corporation.(see Article 10, US-Switzerland Income Tax Treaty; see Article 10, US-Netherlands; see Article 10, US-Ireland Income Tax TreatyIncome Tax Treaty; see Article 9, US-Hungary Income Tax Treaty) Switzerland: Corp Rate: 13-22% Dividend Rate: 15% (35% w/o treaty) Netherlands: Corp Rate: 25.5% Dividend Rate: 15% Ireland: Corp Rate: 12.5% Dividend Rate: 15% Bulgaria: Corp Rate: 10% Dividend Rate: 5% Hungary: Corp Rate: 10% Dividend Rate: 0%

13. WHAT IS THE TAX BENEFIT REALIZED? Overall, this system can produce substantial tax benefits. Take the 2010 movie Winter’s Bone for example. It cost $2,000,000 to produce, just as this hypothetical movie does. It grossed $8,031,021 in theaters in 2010. -1/4 of the $8,031,021 gross will be kept by the film distributor =$2,007,755.25 -1/2 of the gross will be kept by FRHC = $4,015,510.50 -The final ¼ will be passed to the producers and investors in proportion = $2,007,755.25 The distributor’s ¼ will be taxed to them and is not of concern. Assuming the FRHC is placed in Ireland, the tax consequences will unfold as follows: FRHC Income -Irish Corporate Tax: $4,015,510.50 x .125 = $501,938.82 (Tax Liability in 2010) -Irish/US Dividend Tax (The Two Taxes Will Set Each Other Off) $4,015,510.50 x .15 = $602,326.58 (Tax Liability in 2010) FPC Income -US Tax on Royalty (Sale) Payments $2,007,755.25 - ($2,007,755.25 x .09%) x .35 = $639,470.05 TOTAL TAXES PAID: $1,743,735.45 If the money would have simply been paid to the US the tax liability on $6,023,265.75 would have been $1,918,410.14 (taxed at 35% with §199 deduction accounted for). THIS RESULTS IN A TOTAL SAVINGS OF $174,674.69.

14. §367(d) – Future Concerns If FPC sells their stock in the FRHC to an unrelated US party, then FPC must realize gain, as measured by the difference between the FMV upon the transfer of the stock and the basis upon the original contribution. Treas. Reg. §1.367(d)-1T(d)(1) Film Production Company Unrelated 3rd Party Stock Related 3rd Party Film Production Company Stock If the FPC transfers FHRC’s stock to a related US person then such related US persons will be deemed to receive royalty payments in proportion to their ownership of the FHRC stock. Treas. Reg. §1.367(d)-1T(e)(1) Film Rights Holding Company Rights Unrelated 3rd Party If FRHC disposes of the IP to an unrelated party then FPC realizes gain measured by the difference between the FMV on the date of disposition and the basis upon the time of contribution. Treas. Reg. §1.367(d)-1T(e)(1) Related 3rd Party Rights Film Rights Holding Company If the IP is transferred by FRHC to a related party of FRHC then the deemed payment will continue. Treas. Reg. §1.367(d)-1T (f)(3) Any of these occurrences, along with a real or deemed payment under §367(d) will result in a basis adjustments in relation to the stock and E/P adjustments for the FRHC. SEE §1.367(d)-1T.