I was at the excellent Oliver and Ohlbaum media conference a couple of weeks ago where the topic under discussion by a panel of eminent investors and entrepreneurs was whether the UK has the right environment for investment in the creative industries. When the panel discussion was thrown open to the floor, a representative of an investment firm stood up and made a speech about how the problem in the sector is the lack of availability of funds investing in projects i.e. in films, television programmes and the like (as opposed to investment in the businesses that make such films, television programmes, video games etc).
Not surprisingly the panel were non-plussed. Eventually one of the lead panellists responded by asking a question of his own: “Why on earth would anyone invest in projects instead of companies”?
It’s a good question.
One of the issues for the creative industries which makes it more difficult for creative companies to attract investment of any kind is the effect of two common causes of market failure described by economists as: (i) asymmetric information, which leads to the problem of adverse selection, and (ii) moral hazard. Non-economists will have become familiar with the latter term, as it has been much discussed since the onset of the financial crisis; in essence in the creative industries it means a misalignment of interests between investors and owners of creative businesses. Asymmetric information essentially means that it is impossible for investors to know as much about the potential success of the creative endeavours as the creative businesses and it leads therefore to terms being demanded for the best projects being unattractive to the creators, who in turn only offer the more questionable projects to investors.
One of the objectives of government policy has been to encourage the production of films that might not otherwise be made and there are reasons for encouraging such an outcome. Some films may have little commercial promise but may be culturally significant and some marginal projects can sometimes surprise and generate a commercial return. It’s notoriously difficult to predict whether a film will be a success or a failure.
Governments in the last 15 years, and in particular the Labour governments under Blair and Brown, sought to deal with the market failure by offering tax incentives. I would argue that these tax incentives have done nothing but harm to the creative industries by exacerbating the causes of market failure through adverse selection and moral hazard.
Let’s examine the history of tax incentives introduced for British film. These were introduced by the Labour government that swept into power in 1997 after a long period of being left out in the cold.
In the Finance Act 1997 a 100% tax deduction for expenditure on film was introduced. The idea was to give producers a complete tax deduction for the costs of making a British film under £15m (known as Section 48 after the relevant section in the Finance Act 1997) or if the budget was over £15m, a similar tax deduction but spread over a few years was available (known as Section 42 relief after the section in the 1992 Finance Act). That was the idea but it quickly spawned a new beast – sale and leaseback transactions. Crucially the expenditure that qualified for the tax deduction was not only available to the person spending the money on making the film, but also to a person who acquired the film when it was completed. Thus a whole industry was born whereby films were sold to and acquired by vehicles set up by financiers for wealthy investors who could take advantage of the tax deduction for acquiring a film. The film was then leased back to the producer so he or she could do what they wanted to do with the film, i.e. get it distributed into theatres. The investors took no risk on the film, they simply got a 100% tax deduction upfront and had to pay tax on the lease rental income over the next 15 years. The whole thing worked by effectively giving the investors a way of generating a refund of tax which they then had to repay over a 15 year period – in effect a very cheap loan subsidized by the Treasury. The firms that promoted these schemes made a fortune in fees (and they also may have deferred the tax on their profits by doing sale and leaseback transactions themselves!).
It was all perfectly legal, but not the right outcome the policy ought to have been seeking. The film sale and leaseback legislation led to all sorts of schemes, notably television programmes (including soap operas!) at one point were being used to generate the relief, which was only clamped down on in 2002 (along with some other alleged loopholes being exploited). But the overall Section 48 relief, originally supposed to be available for a short period, was actually extended to 2005.
Separate to this but of great significance in what was to come was the introduction of the limited liability partnership in the Limited Liability Partnership Act 2000. This new form of business entity, which had limited liability like a company but is tax transparent i.e. doesn’t pay tax itself but its taxable profits and losses are shared by its partners, was a boon for the industry allowing new structures to be invented. From 2002 onwards new schemes started being offered in the market, which have led to cases, some as yet unresolved, as HMRC goes through the process of reviewing and challenging them. Some of these involved “double-dipping” (getting tax relief for the same expenditure twice), whilst a whole new swathe of so called GAAP schemes was born (so called as they relied on the rule that the tax treatment follows the Generally Accepted Accounting Practice) to create losses which could then be allocated to the partners in different ratios to different members by the agreements governing those limited liability partnerships. Time and again HMRC shut down one alleged loophole (restricting the loss relief available to actual capital invested in 2005 or restricting the availability of the loss relief in 2007) only for the scheme operators to find a new way around the rules. I should make it clear here that I am not suggesting any impropriety or professional misconduct or on the part of any of those operators or giving an opinion on the legality or otherwise of those schemes. That’s for HMRC to decide in due course. So far the biggest case heard though is the case of Eclipse 35 LLP, which the First-tier Tribunal recently decided on in HMRC’s favour.
Eclipse 35 LLP
This scheme was operated and promoted by Future Films. In summary 289 “investors” put up £50m of their own cash into a limited liability partnership which was supplemented by a £790m loan from a subsidiary of Barclays. This total of £840m was then paid out as follows: £503m to Disney, of which £497m was deposited with Barclays and Disney kept £6m; £293m to Barclays as prepayment of interest on the loan; and £44m to Future Films. Eclipse 35 LLP entered into a licence agreement with Disney for two films, which provided for annual payments to be made over 20 years. In practice the initial £503m payment covered the entire 20 years. Eclipse also entered into a distribution agreement with another company in the Disney group which guaranteed to pay Eclipse £1.022bn over 20 years. Disney’s obligation to pay this was secured by Barclays – which had £497m plus interest to cover the payment stream. After year 1 until year 19 in the accounts of the LLP, the interest expense, license fees and admin costs offset the profits from the distribution agreement with Disney, and it is only in year 20 that the LLP showed a net profit of £242m which would be taxable on the members. So overall, all the money went round in a circle in year 1, thereafter the only transactions were accounting entries and in effect, the only real money flowing was from the investors put in £50m, of which £44m went to Future Films and £6m to Disney. Why would they do this? The answer is in the detail of those accounting entries and the fact that the tax treatment follows the accounting treatment. The limited liability partnership paid out £293m in interest expense in year 1 and therefore generated an accounting loss of £293m. To the 40% tax payer investors, this loss was worth £117m. So they put in £50m and got back £117m. In theory they would be required to pay £97m (being £242m at 40%) in 20 years, but even so the scheme appeared to offer free money for some. HMRC won their challenge of the scheme at the First-tier Tribunal on the grounds that the scheme wasn’t operating a trade, hence the tax payers were denied the upfront loss relief they claimed but still could be liable for tax on the profits of the LLP in future years. Future Films are appealing the decision.
Finally the government abolished the Section 42 and Section 48 reliefs entirely in 2005 and replaced them with what in my view should have been introduced in the first place, a tax credit that is available only to the film production company.
Another type of scheme that has emerged since 2005 has been the “protected” or “limited life” EIS or VCT. This has been a structure designed to shelter the investor from the normal risks of investing in companies and get a return, a large part of which is from the tax sheltered which in the case of VCTs was worth 40% (now 30%) after only 3 years (now 5 years). Funds were set up which had a limited life of 3 or 5 years, offering investors capital preservation and even a dividend stream (actually paid out of a proportion of the investor’s subscriptions which weren’t actually invested in any companies at all).
The upshot of all of this is that by comparison investing in companies, even companies making films, television programmes, video games, concerts and festivals etc where these structures couldn’t be applied, looked positively eye-wateringly risky. These structures attracted a lot of money, so it’s not a lack of available capital that the creative industries suffer from, but pitted against tax-structured products offering guaranteed returns with very little or no risk, a company trying to build a business which can’t offer guaranteed returns and no risk suffers by comparison. In fact so much money was available that the constraint for the industry was a lack of available product, so more and more questionable projects got financed simply because investors couldn’t lose. In fact plenty of money has even been invested in blockbuster Hollywood movies, not because those films needed UK investors’ money to get made but because extremely cheap finance was made available to the US studios behind them. UK firms were keen to get involved and offer their wealthy clients a cheap or even free investment, the cost of which was subsidised by the UK taxpayer. Some of that investment could have been put to use in building companies and permanent jobs.
Which brings us back to that very good question – why would anyone invest in projects rather than companies? Surely it is always better to invest in a company, where you are backing a management team and people to build a business that usually has a diversified product portfolio? It is businesses not projects that get sold to larger companies for strategic premiums or can be IPO’ed generating spectacular capital returns for investors. The reason is because poorly designed tax breaks can and have been manipulated to make investing in projects, which should be a riskier endeavour than investing in companies, perversely more attractive. Some would say that does help the health of British creative companies as they need access to finance for projects from multiple sources. That last part is correct but in my view part financing projects with a tax subsidy the use of which is directed by the market is not the right outcome for policy. In so attempting to cure market failure through tax incentives, the Labour government created exactly another, worse, market failure, riddled with adverse selection and moral hazard.
At last however there is a new tax regime that promises to herald a new era in investment in businesses in the creative industries. This tax year sees the introduction of a new tax relief scheme, the Seed Enterprise Investment Scheme, a junior version of the Enterprise Investment Scheme offering investors up to 78% tax relief for investing in new ventures and zero capital gains tax when the investments are sold. Ascension Ventures, a creative and digital sector investment firm, has launched the UK’s first Seed Enterprise Investment Scheme fund, called ASCEND (Ascension Seedcapital for Creative Enterprise and Digital). The firm has also launched a complementary Enterprise Investment Scheme fund, called Ascension Creative Enterprises EIS Fund (offering investors up to 58% tax relief on investment and zero capital gains tax when the investments are sold) to provide follow on capital for graduates from the ASCEND SEIS Fund.
We at Ascension have launched two funds aimed at investing in a new generation of companies, not projects. We are doing so with the support of the SEIS and EIS and doing exactly what the government wants – channelling investment into new enterprises and supplying growth capital to businesses that will build sustainable businesses in the UK’s creative industries, generating employment, earnings, including export earnings, and value for Britain. The SEIS should be a fantastic boost for the creative and digital sector. We and others will be planting seeds today and I believe we will look back in a few years’ time at some mighty oaks that were born around this time.
There is much to be celebrated about Britain’s creative industries – British creatives are often seen picking up awards around the world at film and games festivals. There is a great pool of creative talent in this country but it needs business support and capital, otherwise that talent will move overseas. Sir Jonny Ive is a great British creative whose talent helped transform a near bankrupt company, Apple, into the most valuable company on earth. In Diamond Jubilee year, as we celebrate Britain, we’re going to plant some seeds so that our British talent wins more than just awards or helps overseas companies become world class, and build some world class companies of our own.
The legislation around the SEIS is complex running to over 60 pages. It is hoped that this will make it harder for others to use the SEIS to concoct schemes that defeat the spirit of the legislation. The rules need to be tough and HMRC needs to police them stringently. Past experience has shown how, if I may be permitted to mix economic metaphors, poorly designed tax rules can lead to bad money driving out good.