BIM56420 - Film and audio products: tax deferral schemes for qualifying films: tax treatment of the lessee

Accountancy practice ( BIM56410) will often reflect a sale and leaseback of a film as a single financial transaction, similar to a secured loan on an asset. However the tax treatment is different and treats the sale and leaseback as two separate and distinct transactions.

The sale

The sale of the master version of the film will give rise to a revenue receipt, equal to the sale/acquisition price, in the hands of the seller (lessee) by virtue of F2A92/S40A (see BIM56205 and BIM56243). Any expenditure incurred by the seller on producing or acquiring the master version of the film prior to the sale will be revenue expenditure, and in theory can be written off in a number of different ways under the special provisions for films (these are listed in BIM56415). In practice (presuming the film was not held as trading stock – see BIM56255), when the master version of the film is sold in a sale and leaseback, any expenditure incurred on the film which has not yet been deducted can be written off under the income matching method ( BIM56215): so claims to use any other method would not usually be worthwhile.

Commonly, a producer sells a film for its cost of production, and the sale proceeds are matched by the production costs leaving the producer (lessee) with no taxable profit or loss on the sale and leaseback transactions. From 2 December 2004 ( BIM56340), except for films within the transitional provisions, there is no advantage in selling above production cost as relief is no longer available to the acquirer under F2A92/S42. However, a sale at above production cost (see BIM56335) can lead to a taxable profit. To avoid this, the ownership of the film is sometimes transferred offshore before the sale and leaseback is carried out. In these circumstances, for films costing up to £15m to produce, the provisions at FA02/S101 (prevention of avoidance involving multiple acquisitions) should be considered, as these may apply to restrict relief (see BIM56530).

The leaseback

Following the leaseback, the lessee exploits the film to generate further income. The full amount of the rentals due under the lease will be allowable deductions in arriving at the profits from the exploitation of the film as they are paid. The lessee has not reacquired the master version of the film so its expenditure under the lease is not subject to the special provisions for films.

In effect, what the lessee has is a bundle of rights that are generally exploited in the early stages of the lease period (most exploitation income from a film arises in the first 3 or 4 years). Once these rights have been exploited there is often little likelihood of income being generated by the lessee over the remaining period of the lease. In these circumstances it is proper to recognise the future rental obligations as an expense incurred in earning this income.

Where the lessee can show that there is likely to be insufficient income to meet the rental obligations in future periods you should accept that a provision for this future expenditure is allowable. Such a provision is unlikely to be shown explicitly in the accounts which follow SSAP21 in accounting for finance leases. However, in general, where the lessee can demonstrate that deductions for equivalent rentals under an operating lease would be shown in accounts computed in accordance with UK GAAP, you may accept that treatment for tax purposes.

Where lease rentals are secured by a security deposit, it should be remembered that interest on that deposit is likely to arise over the lease period, so that any provision should normally be limited to the ‘capital repayment’ element of the payments under the finance lease.

Avoidance schemes

In a sale and lease back transaction the accountancy treatment will often not recognise the sale proceeds (see BIM56410), particularly where the seller/lessee places some of the sale proceeds on deposit as security for the future lease rentals. Instead, the accounts may only show the ‘net benefit’ of the sale and leaseback, being the difference between the sale proceeds and the security deposit. The tax computations should amend this to reflect the full sale proceeds, but often in avoidance schemes this is not done. Where this is discovered you should request revised and corrected computations.

This form of incorrect tax treatment of the producer/lessee has often been seen in tax avoidance schemes, particularly those involving deferments and participations ( BIM56385), and may possibly arise in some double dipping schemes (see BIM56360). Deferments and participations are not generally deductible until and unless they become due and payable as they are not costs incurred until then. Where the sale price in a sale and leaseback scheme is set at actual cost plus these notional sums the producer is likely to have a significant taxable profit.

In some cases, the level of profits may be substantially reduced if lease rentals can be written off early (see above). Commonly, low budget films with substantial deferments are unlikely to earn any income: the primary purpose of many such films being as vehicles for tax avoidance. In some cases, early provisions for rental payments may be appropriate and the overall effect may be to give the producer/lessee little net taxable income. However, as the lessees will continue to receive interest income, and to make rental payments, for the duration of the lease it is important that the computations should be put on the correct footing.

It will often be argued that the producer/lessee has no money or resources with which to meet its tax liabilities. Cases should be referred to Anti-avoidance Group (Films) where a tax liability of a seller/lessee has arisen through a sale and leaseback deal, and you have doubts over the ability of the seller/lessee to meet those liabilities.