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Film Production: Basis Recovery and Federal Incentives (Portfolio 599)

Tax Management Portfolio, Film Production: Basis Recovery and Federal Incentives (Portfolio 599), No. 599-2nd, provides a comprehensive analysis of the revenue recognition, basis recovery issues and federal incentives applicable to the media and filmed entertainment industry.

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Tax Management Portfolio, Film Production: Basis Recovery and Federal Incentives (Portfolio 599), No. 599-2nd, provides a comprehensive analysis of the revenue recognition, basis recovery issues and federal incentives applicable to the media and filmed entertainment industry. This Portfolio begins with an overview of the evolution of film production over time and provides a glimpse into the broadcast and cable network television business. The Portfolio continues with an extensive discussion of tax ownership (and common financing and production transactions) and relevant copyright law guidance and topics. The Portfolio then provides a primer on revenue recognition, addressing common fact patterns and issues associated with theatrical film distribution, home video and sales/returns, and other matters. The section was tailored to frame the subject in a manner useful to various types of content producers, licensors and distributors. The Portfolio also addresses the Extraterritorial Income Exclusion and its relevance to media and entertainment companies. The Portfolio then addresses tax basis topics and launches into an analysis of depreciation methods applicable to production properties, including the amortization of intangibles under §167, the history, evolution and application of the income forecast method of depreciation, the amortization of §197 intangibles and basis recovery for abandoned property (including pre-development costs). This Portfolio also covers in detail §181, a federal incentive designed to deter runaway (i.e., non-U.S.) production, and which provides a current deduction for production costs paid or incurred for qualified film and television production. The Portfolio similarly addresses §199 as relevant to the film production (theatrical, free-TV, pay-TV, home video, etc.) and distribution industry. The Portfolio also addresses the recovery of software development and research expenses (and research credit eligibility) with a similar focus and discusses the manner in which certain production incentives might be accounted for under Generally Accepted Accounting Principles (“GAAP”). This Portfolio closes with a discussion of the pertinent issues involved in the disposition of film assets, which is equally applicable to video games, on-line content, and television content.

The creation of this portfolio was spurred by two objectives. First, the authors wished to consolidate and coordinate in one place various pieces of theatrical film, home video, on-line content, cable and television, and licensing arrangement guidance regarding income recognition, basis recovery, and federal incentives. We believe a text that appropriately weaves such strands together, to enable the reader to view the entire tapestry, may facilitate meaningful issue identification and use from a planning and compliance perspective. Second, the authors believe an industry specific point of view, reflecting transactional and business realities, and commentary would be of value to a reader interested in the tax considerations addressed from both a historical and future planning point of view. A note about what this text is not. The text does not address every conceivable deal structure, property interest, technology evolution, or income tax issue. The text was purposefully limited to certain topics so that a more in-depth coverage could be accorded to these topics. The authors have not sought herein to read obscure footnotes from obsolete case law, under poor back-lot lighting, to support general propositions; but, rather, we have endeavored to reflect the state of the law with its areas of clarity and ambiguity from a practical and realistic perspective.


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AUTHORS

MICHAEL H. SALAMA
Michael H. Salama. B.S. (Mathematics), Vassar College (Ford Foundation Scholar in Mathematics); J.D. George Washington University Law School (with honors); MBA (Director's Award: Class Rank 2nd, Operations Management Prize, University Academic Achievement Award) Cambridge University. Vice President of Tax Administration & Senior Tax Counsel, The Walt Disney Company (Burbank, CA). Previous positions include: senior manager, the Washington National Tax Services Group. PricewaterhouseCoopers LLP; senior trial attorney, Office of Chief Counsel, I.R.S., clerk Anti-Trust Division, Department of Justice, Computers & Finance Section. Mr. Salama has published extensively on a variety of topics in the both the federal and state income tax areas.

BRANDEE A. TILMAN
Brandee A. Tilman, B.A. (Economics), University of Colorado, Boulder; J.D., University of California, Davis School of Law; LL.M. in Taxation (with distinction), Georgetown University Law Center. Senior Manager, Tax Controversies & Tax Counsel for The Walt Disney Company. Previous positions include: Graduate Fellow for the Council On State Taxation; senior associate, KPMG LLP. Serves on Executive Committee of the American Bar Association's State and Local Tax Committee and Editorial Board of The Tax Lawyer — State and Local Tax Edition. Selected as one of six members of the 2007–2008 class of John S. Nolan Fellows by the American Bar Association.

TABLE OF CONTENTS

Detailed Analysis

I. Introduction: A Brief History of Film Production

Introductory Material

A. Early Filmed Entertainment and Content Evolution

1. The 1890s Through the 1940s

2. Trends in Talent Contracts Leading Up to the Television Era

3. The 1950s Through the Twentieth Century

4. Emerging Trends in the Twenty-First Century

B. Film Producers Over Time

C. Film Production Technology Evolution

D. That's a Wrap

II. Relevancy of Older Internal Revenue Service Final Published Guidance

A. Introduction

B. Deference to Regulations

C. Overview of Non-Regulatory Guidance

D. Taxpayer Reliance Upon Published Revenue Rulings and Final Guidance

E. Reliance on Technical Advice Memoranda and Taxpayer Specific Guidance

III. Tax Ownership for Depreciation

A. Origins of Ownership: Frequently Utilized Film Production, Acquisition and Distribution Transactions

B. Ownership of What? Tangible vs. Intangible Property and Related Matters

C. Transfer of a Film Interest: Sale vs. Lease or License

D. Sale of a Film Interest vs. Performance of Services

E. Benefits and Burdens of Ownership Analysis

1. The Existence of Purchase Options

F. Financing Transactions: Sale Lease-Backs and Cross-Border Transactions

G. The Danielson Rule vs. Strong Proof Rule

H. Statutory and Common Law Limitations on the Deduction Amount

1. Section 465: At Risk Rules

a. Background

b. General Rules

c. At-Risk Defined

(1) Money and Other Property

(2) Amounts Borrowed

(a) Personal Liability

(b) Nonrecourse Financing and Guarantees

(c) Lenders with an Interest in the Activity

2. Section 183: Activities Not Engaged in for Profit

3. Anti-Abuse Doctrines

a. Step Transaction Doctrine

b. Business Purpose Doctrine

c. Economic Substance Doctrine

IV. Basis Rules Overview

A. Overview

B. Cost Basis

C. Debt as a Component of Basis

D. Common Transactions Establishing Basis

1. Acquisition of Assets

2. Acquisition of Trade or Business that Holds the Assets

3. Section 263(a): Amounts Paid to Create, Acquire or Enhance Intangible Assets

E. Section 263A Capitalization

F. Impact of Film Incentives on Basis

V. Methods of Depreciation

A. Purpose of Depreciation

1. Matching of Income with Expense

2. Recovering Investment in Property

B. Overview of Depreciation Under § 167

1. General Rule

2. Scope of Property Covered

a. Tangible Property

b. Intangible Property

3. Entitlement to Depreciation or Amortization

4. Amortization of Intangibles with Limited Useful Life Under Regs. § 1.167(a)-3

a. Useful Life of 15 Years

b. Special Rules for Certain Transactions

c. Depreciation Method

5. Useful Life Estimated with Reasonable Accuracy

a. General Examples of Proving Limited Useful Life

b. Film Industry Examples

6. Amortization of Intangibles Under Regs. § 1.167(a)-14

a. Amortization of Certain Rights to Receive Tangible Property or Services

b. Amortization of Rights of Fixed Duration or Amount

c. Amortization of Patents or Copyrights

7. Interplay with § 168 Property

C. Placed In Service Requirement

1. Definition of Placed In Service

2. Film Industry Examples

D. Basis for Depreciation

E. Election for Each Item of Property

F. Depreciation Methods

1. Overview of Straight-Line Method

2. Overview of Sum of the Years-Digits Method

3. Overview of the Unit of Production Method

4. Depreciation Methods for Rights to Broadcast Live or Delayed Content

5. Section 467

a. When Applicable

b. Accrual of Rental Payments

c. Potential Application to Film Contracts

G. Income Forecast Method

1. General Concept and Historical Background

2. Chronological History of Applicable Guidance

a. Application to Motion Picture Films and Forecasted Future Revenue

b. Payments by Television Station for the Right to Exhibit Films Over a Limited Duration for Limited and Unlimited Airings

(1) Rev. Rul. 62-20

(2) KIRO, Inc.: Sliding Scale Method

c. Application to Motion Picture Film Production-Service Partnerships

d. Application to Book Manuscripts, Patents and Master Recordings and Early Service Guidance Regarding the Placed in Service Requirement

e. Application to Videocassettes

f. Application to Video Game Machines

g. Application to Rent-to-Own Industry

3. Guidance on Calculation of Income Forecast Method Deduction

4. Transamerica Corp. v. U.S.: Participations and Residuals Included in Total Cost of Film Production

5. Associated Patentees Approach to Treatment of Participations and Residuals

6. Small Business Job Protection Act of 1996 Codifies the Income Forecast Method of Accounting

a. Overview and Effective Dates

b. Determination of Estimated Income

c. Determination of Income Forecast Property Costs

d. Look-Back Method

7. Chief Counsel Advice 199936044: Internal Revenue Service Prior View Regarding Deductibility Under § 404 of Movie Participation Payments

8. Prop. Regs. § 1.167(n): Guidance Issued on the Income Forecast Method

a. Overview of Prop. Regs. § 1.167(n) and Effective Dates

b. Income Forecast Method: In General

c. Income From the Property

d. Property Covered

e. Computation of Depreciation Under the Income Forecast Method

f. Basis

g. Look-Back Method for Computing Interest

9. American Jobs Creation Act of 2004: Resolution of the Participations and Residuals and Gross vs. Net Issues

10. January 2005 Large and Mid-Sized Business Division Directive on Disposition of Income Forecast Method Issues for Taxpayers With Movie and Television Production Income

11. Notice 2006-47

VI. Section 181: Treatment of Qualified Film and Television Production

A. Overview

1. Enacting Legislation

2. Purpose of Enactment

3. State of the Industry

B. Scope of Costs Covered by § 181

C. Statutory Requirements and Regulatory Guidance

1. Production Covered and Effective Dates

2. Tax Ownership Rule

3. Productions Costs

a. Production Defined

(1) In General

(2) Special Rule for Television Series

(3) Treatment of Spin-Offs and Shows That Go on Hiatus

(4) Exception

b. Production Costs Defined

4. 75 Percent Compensation Test

a. In General

b. Compensation Defined

c. Qualified Compensation Defined

(1) Special Rule for Animated Films

(2) Special Rule for Mixed Live Action and Animated Films

d. Special Rule for Acquired Productions

e. Treatment of Participations and Residuals

5. Dollar Limitation

a. In General

(1) $15 Million Dollar Limitation

(2) Treatment of Participations and Residuals

b. Higher Dollar Limitation for Low Income Communities or Areas of Distress

(1) Production Cost Test

(2) Total Days of Principal Photography Test

6. No Placed In Service Requirement

D. Method of Election and Transition Rules

1. Timing of Election - In General

2. Information Required

3. Special Election Permitted: Transition Rules

4. How to Revoke a § 181 Election

E. Impact on Other Depreciation or Amortization Deductions

F. Other Defined Terms

1. Production Personnel

2. Actors

3. United States

G. Cost Allocation

H. Application of § 1245 Recapture Provisions to § 181 Costs

1. Circumstances Requiring Recapture

2. When to Report

3. Recapture Amount

4. Section 1245 Treatment

I. Applicability of § 181 Election to Film Financing Transactions for Individuals

J. State Non-Conformity to § 181

VII. Section 197

A. Overview

B. General Rules

1. Amortizable § 197 Intangible

2. Treatment of Sports Franchises

3. Separately Acquired Interests and Rights

4. Other Special Rules

C. Acquisition of Trade or Business Requirement

D. Computational Issues

1. General Framework for Computing Amortization

2. Contingent Amounts

3. Basis Determinations and Dispositions

a. Basis Determinations

b. Assumed Liabilities: Case Illustration – Acquired Broadcast Rights Contracts

c. Dispositions and Related Issues

(1) Loss Disallowance Rules

(2) Specified Non-Recognition and Exchange Transactions

VIII. Accounting for Abandonment Losses

A. Overview of Deduction of Losses Under § 165

1. General Rule for Deducting Losses

2. Requirements to Establish Abandonment

a. In General

b. Overt Acts of Abandonment

B. Application to Film Creative Development Costs

1. Overview of Film Creative Development Costs

2. Statement of Position 00-2: GAAP Rules

3. Industry Issue Resolution Program

4. Industry Proposals

5. IRS Position and Guidance Issued

a. Revenue Ruling 2004-58

b. Revenue Procedure 2004-36

IX. Section 199: Domestic Production Deduction

A. Overview

1. Section 199 Purpose and Guidance History

2. Computation of the Benefit

3. Entities for Which the Benefit Is Available

4. Treatment Under the June 2006 Final Regulations for Current Film Production Arrangements

5. Treatment Under the Tax Extenders and Alternative Minimum Tax Relief Act of 2008

B. General Application

1. Expanded Affiliated Group Treated as One Taxpayer

2. W-2 Wage Limitation

3. Qualified Production Activities Income

4. Domestic Production Gross Receipts

5. Allocation or Apportionment of Deductions

C. Qualified Film

1. Domestic Content Test

a. Notice 2005-14

b. October 2005 Proposed Regulations

c. June 2006 Final Regulations

d. June 2007 Proposed Regulations

2. By the Taxpayer Requirement

a. Notice 2005-14 and October 2005 Proposed Regulations

b. June 2006 Final Regulations

c. June 2007 Proposed Regulations

(1) Domestic Content Test

(2) Produced by the Taxpayer

3. DPGR

a. Requirement of a Lease, Rental, License, Sale, Exchange or Other Disposition

b. Advertising Income

c. Related Party Rules

4. Qualified Film on Tangible Personal Property

5. Duplication

6. Statistical Sampling for Older Films

7. June 2007 Proposed Regulations: Paid or Incurred

8. Specifically Excluded Sources of Revenue

X. Research and Development Costs

A. Treatment of Certain Costs to Produce and Develop Production and Distribution Technology

B. Software Development Costs

1. Revenue Procedure 69-21 and Revenue Procedure 2000-50

a. Definition of Computer Software

b. Option to Expense or Amortize Development Costs

c. Time and Manner Requirements

2. Automatic Change in Accounting. Rev. Proc. 2007-16

C. Section 174: Research and Experimental Costs

1. Overview

a. Elections to Expense or Amortize

b. Application by Project or in General

2. Research and Experimental Expenditures Definition

a. General Types of Expenditures and Effective Dates

b. Reasonableness Requirement

c. Special Rules for Expenditures for the Acquisition or Improvement of Land or Other Depreciable Property

3. Time and Manner Requirements

a. In General

b. Specific Rules of Revenue Ruling 58-74 and Revenue Ruling 90-38

c. Automatic Consent Procedures Applicable to Research and Experimental Expenditures Under § 174

D. Section 59(e): Optional 10-Year Write-Off

1. Election to Deduct Straight Line Over 10 Years

2. Proposed Treasury Regulations

a. Project Based Accounting Requirement

b. Documentation Requirements

3. Final Treasury Regulations

a. Time and Manner Requirements

b. Specific Dollar Amount Requirement

E. Section 41: Research Credit

1. Overview

a. General Calculation

b. Qualified Research Expenses (“QRE”)

(1) In-House Research Expenses

(2) Contract Research Expenses

2. Definition of Qualified Research

a. Satisfaction of § 174

b. Technological in Nature

c. Development of New or Improved Business Component

d. Process of Experimentation

3. Internal Use Software

a. Section 41(d)(4)(E) Definition

b. High Threshold of Innovation Test

(1) Innovative

(2) Significant Economic Risk

(3) Not Commercially Available

4. Alternative Incremental Credit: Alternative to Traditional Credit

5. Alternative Simplified Credit: Alternative to Alternative Incremental Credit

a. Overview

b. General Computation

c. Industry Application

6. Notable Exceptions

a. Funded Research Exception

b. Style and Taste Exception

c. TSR, Inc. v. Commissioner

7. Two Material Computational Considerations: Defining Gross Receipts and Acquisitions and Dispositions

a. Definition of Gross Receipts

b. Intra-Controlled Group Sales

c. Impact of a Merger or Acquisition on Base Calculations

XI. Disposition of Film Assets Overview

A. Overview

B. Recognition of Gain or Loss: Section 1001

C. Certain Non-Recognition Transactions: Section 1031

D. Capital Gain Treatment and § 1231 Property

1. Capital Asset

2. Section 1231

E. Depreciation Recapture

F. Charitable Contributions


WORKING PAPERS

Working Papers

Table of Worksheets

Worksheet 1 Sample Calculation: Income Forecast Method - Form 8866 (Look-back Calculation) Support

Worksheet 2 Sample Calculation: Income Forecast Method - Film Amortization (Year 5 Look-back)

Worksheet 3 Montana Film Production Incentives: Excerpts from Montana Film Office Web Site

Introduction

Worksheet 4 Excerpts from U.S. Department of Commerce Report, “The Migration of U.S. Film and Television Production: Impact of ‘Runaways' on Workers and Small Businesses in the U.S. Film Industry,” 2001

Worksheet 5 Federal-State Section 199 Conformity Chart

Worksheet 6 Glossary of Commonly Used Terms in the Motion Picture Industry

Introduction

Bibliography

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Statutes:

Treasury Regulations:

Legislative History:

Public Laws:

Treasury Rulings:

Cases:

State Laws:

UNOFFICIAL

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Periodicals:

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