Wanted: Investors to put their money into rebuilding our own film industry

Mailshots were dropping through letterboxes last week asking for £5m to finance The Drop, a Second World War drama starring Ioan Gruffudd and Gerard Butler. It is the latest attempt to pass the hat to keep the ailing British film industry alive.

When cinema-goers bought their tickets to see the Oscar-winning 1930s drama Gosford Park last year, few of them realised that they had already helped to pay for the film as taxpayers. Film finance has been among the knottiest and most tantalising topics of the past 20 years for investors, producers and the Government.

Britain's occasional successes at the annual Oscars in Los Angeles serve only to revive the debate. But, while Hollywood studios often come to these shores to make films such as the Bond and Star Wars movies because of our technical expertise, big City investors have traditionally fought shy of putting money into an industry they see as, at best, unreliable.

In July 1997, when Gordon Brown was newly installed as Chancellor, he hosted a party at 11 Downing Street for British film stars such as Helena Bonham-Carter, Bob Hoskins and Alan Rickman, to celebrate the new tax concession he had unveiled for film investors. But while that proved a useful way of fending off the taxman, its effectiveness at funnelling money into film-making is still in doubt.

Figures from the Inland Revenue show that in the last tax year, investors sheltered £1.4bn of income or capital gains in various film schemes. Despite that, 2002 was the slowest for six years in the UK film industry, and only £165m found its way into the studios, to finance 42 productions. And the outlook for this year is that demand will still remain far stronger for saving tax than shooting scenes.

The Drop, which will be made at the famous Ealing Studios if it gets its £5m, is one of the few single-film projects, and for that reason involves easily the most modest cash call. It is being set up as an enterprise investment scheme (EIS), a form of financing specifically designed to encourage investment in high-risk ventures.

Investors gain income tax relief at 20 per cent of their investment up to £150,000 in any tax year, and they can defer a capital gain made in the 36 months before the date of investment. All capital gains inside an EIS are tax-free and an EIS falls outside inheritance tax (IHT). But they can lose their entire stake. Because EIS film projects are so risky, funds only trickle in. Most of the £1.4bn flowing into the industry last year went into film partnerships, of which there are two main types. One is an ultra-safe way of delaying tax bills, the other is as risky as an EIS.

The risky version is a film production scheme. This is a real investment which reaps the profits and the losses. The schemes appeal to investors interested in taking a gamble that the film advisers will find productions to match at least their budget in sales.

These schemes work only if the films generate income from sales to distributors of at least 5 per cent more than their cash budget, so a £2m budget film must have partnership income from net sales of at least £2.1m. Adding in typical sales commission and expenses of 20 per cent, this implies gross sales of 131 per cent. This is a major risk because the first hurdle is to persuade cinemas to show it.

Investors put £40m into these schemes last year, a drop in the ocean compared to the amount pumped into the far more popular but far less risky other form of partnership: sale-and-leaseback schemes. These are tax-deferral ways for investors seeking a cheap loan from the Inland Revenue for 15 at 5 to 5.5 per cent a year. Investors put up 21 per cent of the income to be sheltered, take out a loan for the balance and get up-front tax relief of 40 per cent. This leaves them 19 per cent cash-positive, which is clawed back by the Revenue over the next 15 years. Producers sell their completed British-certified films to these schemes and get a cash injection of 15 per cent of the film budget.

Most of the funds put into film schemes last year went into this type of product, referred to as Section 48 schemes because they are based around Section 48 of the 1997 Finance Act. The only risks for investors are that marginal rates of tax increase over the 15 years, increasing the effective interest rate on the loan, or the bank guaranteeing the loan hits difficulties, which is unlikely. There is no film risk, and hence almost no upside potential.

Craig Reader, who runs film funds for Close Brothers, the City investment bank, says: "Our investors are all high net worth individuals mainly concerned with sheltering several hundred thousand pounds from tax and preserving their anonymity. The sale-and-leaseback funds are safe, but investors who feel they know what they are doing invest in production funds. Our first two have got their money back, and we are reinvesting it. But it is too early to say how profitable the films are, because they will, hopefully, make money over the next 10 years."

Close takes a conservative approach. It gets banks such as Barclays and Royal Bank of Scotland to put up four-fifths of the money, then goes for big-name stars and sells the films to distributors. "We don't want to be exposed to what the critics or the public may say about a film," Mr Reader says.

The future of Section 48 is being debated by the culture, media and sport select committee, chaired by Gerald Kaufman MP, because it is to be withdrawn in two years. Although Section 48 is thought of as a tax break, it is only a tax deferral. And it is loathed by the Inland Revenue, which last year persuaded the Chancellor, Gordon Brown, to exclude made-for-television productions. But Section 48 is loved by the film industry, because of the 15 per cent cash injection into a film's budget.

The select committee has heard from luvvies and industry lobby groups who want Section 48 retained in some form, saying it is keeping the film industry alive in Britain, with the hundreds of jobs that involves, and export sales from occasional hits such as The Full Monty or Four Weddings and a Funeral. But Mr Brown has to make the harder-nosed decision on whether the Exchequer gets full value for money in the tax deferral. Anyone thinking of investing in films should talk to a financial adviser first.

Martin Churchill is editor of Tax Efficient Review. Readers can obtain a free copy of the Tax Efficient Review's Key Facts Guide to Film Schemes from www.taxefficientreview.com