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Challenges to Financing Canadian Films

One of the biggest hurdles to film production in Canada, and likely any other jurisdiction, is the ability to acquire sufficient funding to complete a production.  Sometimes producers have an established reputation and can easily obtain private financing.  Usually, however, these opportunities are restricted to big blockbuster films.  For smaller films, with limited access to cash, there are a number of government agencies that provide different types of funding to burgeoning Canadian producers. 

In Canada, public financing now accounts for 51% of total financing of local feature films.  According to “Profile 2006: An Economic Report on the Canadian Film and Television Production Industry”, 30% of financing for a film comes from public funding agencies such as Canada Feature Film Fund, Canadian Television Fund (Equity Investment Program), Telefilm Canada and various government departments and agencies.  The remainder of the funding is provided indirectly through federal tax credits at 7% and provincial tax credits at 14%.  During the same period, private financing represented only 12% of Canadian feature film financing. 

Considering the heavy reliance on public funding, it is not surprising that industry supporters spend a lot of effort lobbying the government to maintain, if not increase, the amount of available funding for productions.  However, both the federal and provincial government argue that it is challenging to find support for all these programs.  Film tax credits offered by both governments are often the most highly criticized because the government argues that the amount spent over the course of a year is unpredictable.  In fact, in the 2004/2005, the federal government spent $19 million on tax credit claims.  Provincial governments spent $35 million.  Both figures exceeded the amount budgeted by the government.  On the other hand, direct funding programs like Telefilm or Canada Feature Film Fund are provided with a specific budget to be allocated based on strict eligibility criteria and no flexibility is provided for distributions over the designated budget.  For this reason, the government finds this alternative more attractive.  However, the argument against converting all funding into this formula is that the criteria are overly restrictive and subject to the discretion of those in power in these departments and agencies.  It is argued that many excellent feature films would not be made because one individual or the department may have biases against a certain genre, plot, or producer. 

There is no simple solution to this problem.  For this reason, both programs continue to exist in order to allow all productions equal opportunity of obtaining the necessary funding.  Despite the fact that many provinces, including British Columbia and Ontario, have attempted to phase out the use of tax credits, it is unlikely they will be successful without great resistance unless the film financing system is completely overhauled.  Without the tax credit system, what remains is a completely discretionary funding program that may see the cultural landscape of Canada dictated by a few.  This does not seem like the best result for Canada.

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Is Your Transaction "GAAR"able? A Review of Univar Canada Ltd. v. The Queen

Every taxpayer has the right to structure their affairs in a manner that exposes them to the least amount of tax liability possible.  However, this right has its limits.  As a means to this pursuit, taxpayer’s must not structure their affairs to intentionally avoid or abuse or misuse any provision in the Income Tax Act.  This fundamental principle in tax law was at issue in Univar Canada Ltd. v. The Queen. 

In Univar, the taxpayer carried on an industrial and agricultural chemical processing and distributor business.  The parent company Univar Corporation (UC) owned two subsidiaries.  One incorporated in the Netherlands (UE) and the other in Canada (Univar).  UC loaned UE approximately US$27 million.  Shortly after the loan was made, Univar incorporated a subsidiary in Barbados (Bco), and subscribed for shares valued at US$27 million.  Barbados subsequently purchased the UE debt from UC.  As a result, UE’s interest payments on the debt were made to Barbados instead of UC.  Barbados later paid dividends to Univar net of 2.5% tax rate applicable in Barbados.  Univar treated the dividends as received from exempt surplus and accordingly, deducted the full amount under section 113(1)(a) of the Act pursuant to the foreign affiliate rules for its 1996 to 1999 taxation years.

The Minister disagreed with Univar’s treatment of the dividends as exempt surplus dividends and instead re-characterized the payment as interest.  The taxpayer appealed to the Tax Court of Canada.  At the Tax Court, the Minister argued that Univar received a tax benefit from the incorporation of Bco and avoided paying tax on the interest payments between Bco and UE.  The Minister relied on subsection 95(6) and section 245 in support of this argument. 

Section 95(6) provides that where a taxpayer acquires shares of a corporation and the principal purpose was to avoid, reduce or defer tax then the shares will be deemed not to have been acquired.  In this case, if the provision applied, Univar would be deemed not to have had any shareholdings in Bco.  The court, however, found that Univar’s decision to incorporate Bco was not primarily tax driven, but was implemented for business purposes.  At the time Bco was acquired, Univar had excess cash in its operations that it was planning on using to expand its current operations.  In addition, the appellant presented evidence that its debt to equity ratio was below the ideal ratio.  In order to improve the ratio, the company considered borrowing money that would generate a rate of return that would exceed its interest rate.  Further, the group of companies had guarantee fee issues in the US that could potentially put them offside of Internal Revenue Code 956 and an excessive amount of debt located in UC.  The structure was implemented to ameliorate some of these concerns.  Based on this evidence, the court found that section 95(6) did not apply.

With respect to the Minister’s alternative argument under the general anti-avoidance rule (GAAR) in section 245, the court determined that there was no tax benefit nor was the transaction an avoidance transaction as required under the provision.   Further, the court stated that the hypothetical scenario used by the Minister as an alternative comparative transaction was not representative of the options available to the taxpayer.  The Minister had argued that the group of companies could have arranged their affairs to allow interest payments to be payable directly from UE to Univar.  However, as mentioned earlier, the facts did not support this proposition, but instead supported the arrangement on business reasons. 

In light of the recent GAAR Supreme Court of Canada decisions in The Queen v. Canada Trustco Mortgage Company and Matthew v. Canada (also referred to as Kaulius et al. v. The Queen) issued on October 19, 2005, there is still uncertainty about how the courts will apply the anti-avoidance provisions under the Act.  And less certainty about how the upper courts will apply the provision in Univar if it is appealed.  It will be interesting to see where the GAAR decisions lead us next with respect to establishing clear benchmarks for transactions that may be subjected to this re-characterization provision.  However, it will be more interesting to see how Finance responds by way of amendments in hopes of fine-tuning an already complicated piece of legislation.  In the interim, tax planners should proceed with caution as they structure their plans in accordance with the most fundamental principal in tax:  the freedom to structure one’s affairs in a manner that exposes them to the least amount of tax liability.

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Notice Under Internal Revenue Service Circular 230

In accordance with Internal Revenue Service Circular 230, we inform you that any discussion of a federal tax issue contained on this blog (including any attachments) is not intended or written to be used, and it cannot be used, by any recipient for the purpose of (i) avoiding penalties that may be imposed on the recipient under United States federal tax laws, or (ii) promoting, marketing or recommending specific tax advice.


BC Finance Minister Announces Extension of Tax Credit

Since the release of the Film and Television Industry Review report conducted by InterVISTAS and released in early 2005, it was anticipated that the BC film and television tax credits, once it expired at the end of March 2006, would not be extended.  The 2005 report indicated that the government was losing a significant amount of revenue as a result of offering these credits.  This prompted a dialogue between government officials and film industry supporters.  The government was concerned that it could no longer justify offering the credits based on the reported loss in revenue.  Industry proponents countered the report, however, arguing profusely that the indirect benefits far outweighed the seemingly low direct returns on the government investments.

The Finance Minister, Carole Taylor, obviously heard the industries arguments and responded positively in her announcement that the government would extend domestic and foreign location tax credits, valued respectively at 18% and 30% of eligible labor costs, until 2008.  Although the Minister acknowledged that there was a clear competitive advantage to offering the credits, she also emphasized the need for the industry to increase the attractiveness of filming in BC by exploiting other benefits like local expertise and landscaping. 

The announcement has kept the door open for domestic and foreign location productions to continue taking advantage of the BC film tax incentives for at least another two years.  However, it is likely that when this issue is revisited in 2008 industry players will have an increased challenge of trying to justify the industry’s reliance on these credits.  At that point, if they are unable to justify the necessity of these credits, we can expect to see lights out, or at least a dimming of the lights, on the BC film industry.

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2006 International Film and Video Tax Incentives (Federal)

Often local film producers are confronted with financial limitations that may force them to look to other jurisdictions that provide attractive financial incentives to offset the cost burdens of a particular production.  Popular incentives are often tax driven.  Below is a list of International Film and Video Tax Incentives that may be helpful in deciding which location would provide the best tax advantage for a foreign location production.

Jurisdiction

Description of Tax Incentive

Australia

12.5% refundable tax credit based on qualifying Australian production expenditures.  100% capital cost allowance deduction.

Canada

25% film or video production tax credit directed at Canadian owned productions and a 16% foreign location production tax credit.

Fiji

5% tax credit for expenses related to a locally funded production valued at a minimum F$250,000, which must be at least 35% of the budget.

France

20% tax credit based on production expenditures.

Germany

100% tax deduction based on investment.

Ireland

18% tax credit on Irish expenditures and a 80% capital cost allowance deduction.

Luxembourg

30% tax deduction

Netherlands

100% tax shelter deduction.

United Kingdom

20% tax credit accessed through sale-leaseback structure.  100% of a UK film’s budget worth approximately 20% of production costs. 

United States

Tax-free write-off of expenses related to domestic productions valued under $15 million.  9% deduction for expenses related to domestic productions to a maximum of 50% of wage expenditures.

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What is the Purpose of this Blog?

This blog was started to capitalize on my passion for mining information and to provide my readers with knowledge about tax planning strategies and compliance requirements under the Canadian Income Tax Act.  Since its inception, it has been expanded to also include the US Tax Code.

Postings will relate primarily to corporate and financial services tax issues.  Topics of discussion will include cross border tax, international tax and transfer pricing issues.  However, it may also include discussions of other areas of law, whenever it is relevant. 

The blog will provide commentary on cases, emerging legal issues and recent developments in tax law. 

Please feel free to post your comments under any posting, or send us your feedback about the blog by clicking on the "Email Me" link.


Conducting a Real Estate Business Through Multiple Non-Resident Corporations: How to Stay on Side of Subparagraph 95(2)(a)(i) of the Income Tax Act

Many Canadian Real Estate corporations run their businesses in countries other than Canada. Under the Canadian Income Tax Act such a corporation is required to provide information about any business activities and report any income earned in other jurisdictions whether taxable or not. In particular, the Canadian corporation is required to specify whether the income is foreign accrual property, which basically means that it is immediately taxable to the Canadian corporate taxpayer, or if it re-characterized as active business income, and therefore not taxable until repatriated to Canada. The circumstances in which income will be re-characterized as active business income are provided under the foreign affiliate rules contained in the subparagraphs under 95(2)(a). A subset of this provision could potentially have significant tax consequences if applied to the typical real estate business with a portfolio containing foreign property.

Generally, income from property will be included in computing a taxpayer’s income at the time it is earned by the foreign affiliate. However, there are a few exceptions. For example, where the principal purpose of the business is to earn income from property the income will not be subject to immediate taxation if it is:

  • A business carried on principally with arm’s length parties; AND
  • An affiliate that employs more than five full-time employees in the active conduct of the business; AND
  • Carrying on a qualifying business.

Therefore, if a company primarily involved in the real estate business conducted its business with arm’s length parties and employed more than five full-time employees, the company will have to also be considered a "qualifying business" in order to defer payment of tax on its income until it is paid to the Canadian corporation. Since the Act specifically provides that a qualifying business includes the development of real estate for sale and the leasing or licensing of property, this criteria would also be met and the Canadian corporation could safely avoid paying tax immediately.

However, there are situations where this test may not be met if the company is structured incorrectly, although the substance of the business remains the same. For example, 95 (2)(a)(i) of the Act provides that where the income of the foreign affiliate (FA1) is directly related to the activities of another foreign affiliate (FA2) and the income would have been considered active business income of FA1 had it been earned by it, then it will be treated as active business income and not immediately taxable. In a situation where FA1 holds a portion of its real estate portfolio in different entities for commercial reasons, but still runs the business and retains ownership of some property then the re-characterization rule will apply. However, if FA1 were to move all its real estate holdings into FA2 and provide management services to FA2, the income received will be deemed to be income from a separate business that is immediately taxable. Economically there is no difference in either one of these structures, but the CRA treats the second more harshly for tax purposes.

Many proposals have been made to the Department of Finance to change the unequal application of this rule to permit either structure to be free from immediate tax. Finance has not been receptive to these proposals and the CRA continues to enforce this provision aggressively where the second structure is used and the FA1 is providing management services for FA2’s real estate holdings. Unfortunately, because many clients create this structure without consulting a tax professional it is often a bigger issue to adjust the structure in a way that won’t adversely affect the client commercially or otherwise. Where possible, considering the impact of not complying with the requirements under 95)(2)(a)(i), real estate companies should seek the advice of a tax professional in advance of creating a foreign ownership portfolio. If this is not done in advance, however, the reverse tax planning could prove to be very intensive.

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