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Guide of incentives to the audio-visual productions in Canary Islands Document prepared by Ernst & Young Abogados


Index - IntroductIon - The Cinema Act model in Spain - GeneratIon of tax benefits - The tax allowance for film- production activities - Application of the tax incentive: Economic Interest Groupings - The application of the EIG System and the allowance for Canary Islands Investors: an example - Reserve for Investments In the Canary Islands (RIC) - Canary Islands SpecIal Economic Zone (ZEC) - Summary table


Introduction Canary Islands has one of Europe’s most powerful tax incentives for film and audiovisual production. With a special tax system of their own, validated both by Spanish national regulations and by EU regulations, the Canary Islands offer film tax credits of up to 38% of the total film budget, including expenses made both in Gran Canaria and outside the island. In recent years there has been a boom of tax incentives for the audiovisual sector in other European countries that have imple- mented a range of public grants to film production companies as a result of this sector being considered as an activity of special interest, not only from the cultural point of view but also from the industry side. Thus, we may point out the following countries with special film tax incentives:

Canary Islands has become a first-rate international destination that in recent years has hosted a great number of national and foreign productions due to the possibility of enjoying a tax bene- fit of up to 38% of the total film production expenditure, without forgetting the fact that the island has many geographical and artistic locations of particular interest. This guide seeks to provide to producers and potential private investors a practical explanation of the tax incentives that can be generated with the production of audiovisual works in Canary Islands and how these can be used, with a view to develop the Island’s potential as a natural set and as the birthplace of a powerful film industry.


The Cinema Act Model In Spain The current legal framework of the audiovisual sector has the clear aim of protecting and promoting audiovisual and cinematographic works both from the cultural and industrial point of view. Thus, although there has been a decrease in direct public grants to audiovisual productions, lawmakers have not only maintained, but also improved and encouraged a protection scheme for this sector by means of tax incentives. Within this framework, the Cinema Act and its implementing regulations1 were passed in the year 2007. This act provides the main tax support measures for the sector, reinforcing the regula- tions already set forth by the Corporation Tax Act. This way, with the intention of allowing a better use of the exis- ting tax incentives, the Cinema Act entrusts the Institute of Cinematography and Audiovisual Arts (hereinafter, ICAA) and the Directorate General for Taxation of the Ministry of Economy and Finance with the task of encouraging: .

- The creation of Economic Interest Groupings (hereinafter, EIGs) and Venture Capital Companies to allow the access of investment capital outside the film industry sector, which, as a return on their investment, will receive tax credits that may be offset against their individual tax invoices. Likewise, producers may have access to very advantageous sources of private financing.

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- An efficient system whereby producers and investors may consult the Tax Authority how to have access to tax credits in a quick and simple manner. This system seeks to provide legal certainty both to producers planning new audiovisual projects and to the private investors who acquire the tax credits arising from their film-production investments.

Thus, section 27 of the Regulations implementing the Cinema Act provides that: . “1. Economic Interest Groupings whose corporate objects, pursuant to their registration at the Trade Register, are the activities relating to the production, distribution or exhibition of films or related technical industries may apply for the grants available to them according to their activity, on an


equal footing with the rest of the companies engaged in that activity. . 2. Likewise, those companies or Economic Interest Grou- pings that join as co-producers of a film, in all cases before completion of the production process, shall be deemed to be the producers of this film and may apply for grants for the amortisation of feature films, with the expenses incurred by both the Economic Interest Grouping and the original film production companies being considered as costs.� In this connection, although, due to the current financial crisis and EU harmonisation criteria, the main tax allowances and incentives for other types of activities (such a vocational training, use of renewable energies and environmental protection) have been gradually removed from the Corporation Tax and the Personal Income Tax over recent years, the periodical Spanish Finance Acts and their individual accompanying acts have been extending the possibility of generating and applying tax incentives arising from film-production investments.

1 Cinema Act 55/2007, of 28 December, and Royal Decree 2062/2008, of 12 December, implementing the Cinema


Generation of Tax Benefits The purpose of the scheme provided by the Cinema Act and the Corporation Tax Act is that companies outside the audiovisual industry sector may invest in film production and obtain a number of tax and financial benefits by way of return on their investments. Through this scheme, film production companies may also have available an advantageous financing source for their projects. The model drafted by lawmakers for benefiting from these tax incentives is based on two main pillars: -The generation and application of the tax allowance for film-production activities provided by section 38 of the Corporation Tax Act. - The grouping of private investors in EIGs.

The tax allowance for film-production activities The allowance for film-production investments is the most relevant tax incentive in this matter since, as we will see, it generates a deduction in the producer’s Corporation Tax liability equivalent to 38% of the investment made in the audiovisual work. Pursuant to the Spanish Finance Act for the year 2013, the allowance for film-production inves- tments will be in force till 31 December 2014, 1

so that those film productions completed prior to that date may benefit from it . .

This allowance is regulated by section 38.2 of the Corporation Tax Act and may be applied in either of these two ways: • The investment made in a Canary Islands production considered a feature film will generate a 25% allowance for its financial coproducer. Financial co-producers are those entities that take part in the production exclusively by the contribution of financial resources for an amount not lower than 10% or higher than 25% of the total production cost, in exchange for the right to a share in the revenues to be earned from the exploitation of the film. Thus, as provided in the Corporation Tax Act, the financial producer does not assume the making of the audiovisual work directly and its


participation is limited to a financial contribution in expectation of obtaining revenues from the subsequent exploitation of the film production. • And in a more relevant manner, investments directly made by producers themselves in Canary Islands works classified as feature films or audiovisual fiction, animation or docu- mentary series that allow the preparation of a preliminary physical medium prior to their industrial mass-production will generate a 38% allowance over the investment made. 1 As of the date of preparation of this document, there is a committee crea- ted by the Ministry of Education, Culture and Sports, the Ministry of Finance, the Ministry of Economy and the Ministry of Industry, in charge of drafting the rules that will govern the application of film tax incentives after 2014.

Requirements for application of the 38% allowance for film producers. Who qualifies for the tax allowance? Corporation Tax regulations do not define the meaning of the terms “producer”, “Spanish production”, “feature film”, “au- diovisual series” or “preliminary physical medium prior to the industrial mass-production”. For this reason, in order to esta- blish the concepts that determine the application of the tax incentive it is necessary to resort to the Intellectual Property Act and to the Cinema Act itself, 1

which, in its section 4 includes the basic definitions . This allowance is meant only for Canary Islands investors who pay taxes in Spain by way of Corporation Tax or Personal Income Tax and obtain earnings from business activities and who make investments in Canary Islands feature films or audiovisual fiction, animation or documentary series that allow the preparation of a preliminary physical medium prior to their industrial mass production. In other words, the Canary Islands companies and natural persons who carry on business or professional acti- vities will be those who, by investing their capital in the budget of the audiovisual work may benefit from the tax incentives described below. From the aim and the spirit investors with an economic application of the allowance economic activity in mainland 2

an 18% rate .

of the incentive it would appear that only those activity based in the Canary Islands qualify for at the rate of 38%. Companies with their seat of Spain are also entitled to the allowance, but only at


Pursuant to the criteria of the Directorate General for Taxation in its construction of the Intellectual Property Act, a film pro- ducer is a natural or artificial person who owns the copyrights over the work and who assumes the lead and responsibility for the production. 1 In its replies to many consultations, the Directorate General for Taxation has been relying on the Cinema Act and on the Intellectual Property Act for construction of the requirements for qualification to use the tax incentive. See, among others, the consultations with reference numbers V2007-12, V1598-12 and V0558-11. 2 The Directorate General for Taxation has not yet confirmed whether investors without an establishment in the Canary Islands may benefit from the increased tax incenti- ve rates provided by the Economic and Tax System of the Archipelago. In favour of the use by companies established in mainland Spain, Tax Consultation No. 774/2002 provides that peninsular members of a Canary Islands joint venture (UTE, for its acronym in Spanish) may benefit from the increased rates. Likewise, in order to avoid discrimination between peninsular investors and foreign investors (who would not be able to apply the tax transparency system), it would appear that the entitlement to application of the 38% allowance should be recognised to the latter. Having said this, in order to avoid a possible tax regularisation by the Tax Authorities, we understand that it would be advisable that only entities with Canary Islands stockholders should make use of the increased tax incentive rates.

Basis for calculation of the allowance The Directorate General for Taxation has confirmed in its replies to a number of consultations that the basis for calculation of the allowance must be considered equal to the ÂŤproduction costÂť, i.e., the whole amount used for acquisition of 1

goods and services required for production of the work which may be accounted for as production costs. Thus, investments that form part of the allowance as- sessment base include production expenses, artists’ fees, technical staff, dubbing, film developing, accommodation and maintenance costs, etc. These investments, however, exclude film distribution or marketing costs, grants obtained from any entity and 2

the part financed by the financial co-producer, if any . It is necessary to point out that, unlike film tax incentives in other EU countries, there is no limit to the cost that may be used to generate the tax incentive and that the base for assessment of the tax incentive is the total cost of acquisition of goods and services, i.e., the aggregate of the costs incurred in Gran Canaria and the costs incurred outside the island. On the other hand, the allowance rate for producers is 38%. The profitability for private investors is thus maximized, since, although they only finance a part of the total film budget, the basis for calculation of the allowance is the total investment


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in the feature film . 1 Consultations to the General Directorate for Taxation numbers V1100/2008 and V0643/2005. 2 Consultation to the Directorate General for Taxation number V1366-07: “The part of the investment financed with grants shall not qualify for calculation of the tax allowance. Therefore, the allowance assessment base to be considered in the Corporation Tax return for the year 2006, for the film commenced and completed in that year, would be the production costs less, in an applicable case, the part financed by the financial co-producer, since no part of the cost has been financed with grants, given that these could not be applied for or obtained, as described in the consultation.” 3 Forinstance,a100-currencyunitsfilmbudget30%ofwhichisfundedbytaxinvestors and the remaining 70% by international pre-sales and TV channels, will generate an allowance of 38 currency units.

What productions qualify for the film tax credits? For an investment to qualify for tax incentives, the audiovisual work must comply with the following requirements: • Feature films. Pursuant to the definitions contained in the Cinema Act, a feature film is an audiovisual work contained in any medium, in the production of which the creation, production, montage and post-production works are clearly defined and which is primarily meant for its commercial exploitation in cinemas. Likewise, films with a length of sixty or more minutes will be considered feature films. The allowance is generated by the investment in audiovisual works that allow the “preparation of a preliminary physical medium prior to their mass4

production”. According to the rulings of the Directorate General for Taxation , a preliminary physical medium must be understood as the production of a precommercial master copy or master physical medium prior to the mass-production of the work in question. Therefore, the mere production of screenplays or intellectual works that do not generate such a medium does not qualify for this tax allowance This definition would also exclude from this tax benefit those investments in audiovisual productions meant for their exclusive commercial exploitation in television or other broadcasting media, except where these comply with the requirements provided in the following paragraph. • Audiovisual fiction, animation or documentary series. An audiovisual series is an audiovisual work consisting of a set of fiction, animation or documentary episodes, with or without a generic common title, meant for their broadcast by television operators.


• The production must include at least two week’s filming in interiors or exteriors in the Canary Islands, except where, for duly justified reasons, the filming cannot be carried out at the Archipelago. • The work must fulfil the requirements needed to obtain the Spanish nationality and obtain the classification as a Canary Islands work. The Cinema Act considers as works of Spanish nationality those made by Spanish producers or by producers of another EU member-country which have been granted the Spanish nationality certificate by the Institute of Cinematography and Audiovisual Arts, an entity dependent on the Ministry of Education, Culture and Sports. Works made with foreign companies under a co-production system pursuant to the provisions of the Cinema Act implementing regulations are also considered to be of Spanish nationality. 4 Consultation dated 6 September 2000.

In this connection, section 13 of Decree 18/2009, which created the Canary Islands Register of Audiovisual Works and Companies, for a work to be considered a Canary Islands work, requires the production to be made by Canary Islands audiovisual companies or by co-producer companies acting jointly with at least one Canary Islands audiovisual company registered with the Register of Audiovisual Works and Companies, and include at least a Canary Islands technical or artistic participant (team leader, leading actor or actress and/or supporting actor or actress residing at the Canary Islands). In short, pursuant to the requirements described above, the EIG generating the tax incentive must have its registered office in the Canary Islands and be registered with the Register of Audiovisual Works and Companies of the Autonomous Community competent agency. In addition, the audiovisual work produced by this EIG must fulfil the technical and artistic requirements also explained.


Application of the tax incentive: Economic Interest Groupings In the scheme of tax incentives for film-production in- vestments established by the Cinema Act, the EIGs play a fundamental role, as shown by section 21 of the said Act, which provides that: 2. For a better use of the tax incentives provided in tax regulations, in particular those regulated by sections 34.1 and 38.2 of the consolidation of the Corporation Tax Act, approved by the Royal Legislative Decree 4/2004, of 5 March, the Institute of Cinematography and Audiovisual Arts will encourage: The creation of economic interest groupings (...).� The EIGs are entities with their own legal personality and a very flexible corporate organisation allowing the crea- tion of such an EIG for each single film production project in a straightforward manner. The mechanism for individual members to join or withdraw from the EIG is very simple and these entities are not subject to a minimum capital requirement. This particularly simple system allows the creation in a reasonable manner of the following scheme of contractual relationships:

An EIG may be created either by private investors of the Canary Islands or by executive producers with which the Grouping formalizes the film production agreements.


For a producer to qualify for the allowance it is essential that it is the producer who assumes the lead and respon- sibility for the audiovisual work. Thus, pursuant to the Ci- nema Act, the EIGs themselves will assume the production risks acquiring likewise the ownership of the copyrights over the film work1. Finally, the creation of an EIG, the contributions and reductions of capital and the winding up of an EIG are not subject to the Canary Islands General Indirect Tax. These transactions are subject to, but also exempt from, the Transfer and Stamp Tax. 1 Consultation to the Directorate General of Taxes of 10 February 2006: “Here lies the difference between the financial co-producer and the producer or co-producer. The producers or co-producers share in the lead and responsibility for the work and must be the owners of the rights arising from the property of the audiovisual works produced in the proportion corresponding to each of them. If these characteristics are present in several co-producers, these may apply the allowance provided by section 38 of the consolidation of the Corporation Tax Act (TRLIS), with the tax regulation not requiring a minimum share in the rights arising from the production�.

Special Tax System applicable to EIGs: Tax-transparent entities As business companies, EIGs have the consideration of Cor- poration Tax taxpayers. Notwithstanding, it happens that there is no effective taxation for these entities by way of Corporation Tax depending on the country of residence of their members. Thus, if an EIG is owned by members non- resident in Spanish territory, the entity shall have to pay its Corporation Tax in the standard manner, whereas if it is owned by members residing in the Canary Islands, an EIG will be considered to be tax-transparent. This tax transparency allows members to impute directly in their Corporation Tax returns the tax allowances, tax rebates, positive and negative tax bases, financial ex- penses and withholdings generated by the EIG. Therefore, if for the production of a film an EIG generates a tax credit consisting in an allowance in the Corporation Tax, this allowance may not be credited and applied by the EIG, but it will be automatically transferred to the EIG members in proportion to the capital contributed by each of them. Time of generation of the allowance by an EIG and time of allotment of this tax credit to the EIG members As provided by the Cinema Act, the rate of the allowance generated is 38%, and this allowance must be applied star- ting from the accounting period in which the film production is completed.


Although the Corporation Tax regulations do not contain any provision regarding the time of completion of the production, it would appear that it would be best to consider that the work has been completed after it has been classified by the Institute of Cinematography and Audiovisual Arts and/or by the relevant agency of the Canary Islands Government or when the standard copy has been obtained. Given the particularities of the film market and its specific pre-sales and distribution channels, it should not make sense to apply other criteria, such as the coming into ope- ration or the generation of revenues. Limits to the application of allowances The Canary Islands members of an EIG may apply the allowance in their Corporation Tax or Personal Income Tax returns, pursuant to the provisions of section 44 of the Corporation Tax Act in relation to section 94 of the Act 20/1991, of 7 June, on the modification of the tax aspects of the Canary Islands Economic and Tax System. Thus, the film-production investment allowance will be applied after deduction of the allowances for the avoidance of domes- tic and international double taxation and the tax rebates provided in chapters II and III of Title VI of the Corporation Tax Act. For these purposes, for Canary Islands investors, the limit for application of the allowance is of up to 70% of the total tax liability less allowances for the avoidance of domestic and international double taxation and tax rebates. It has to be pointed out that section 1.1.3 of Royal Legisla- tive Decree 12/2012, of 30 March, which introduced seve- ral tax and administrative measures aimed at the reduction of public deficit, modifies -with effect exclusively for the tax periods commencing in the years 2012 and 2013- the limit set forth by section 44.1 of the consolidation of the Corporation Tax Act, so that the limit provided in the last paragraph of the said section will be 60% of the total tax liability in relation to allowances applied in the tax periods commencing in the years 2012 or 2013. The unused portion of an allowance in a specific tax period may be used in the following 15 years. Exploitation of the work by an EIG The cinematographic work must be kept in operation for 3 years and the owner of the production must retain the rights over the work throughout this period, pursuant to the provisions of section 44 of the Corporation Tax Act. If these rights should be transferred prior to the expiry of the mentioned 3-year period, the deduction would have to be regularized together with the corresponding late-


payment interest. In this regard, the Directorate General for Taxa- tion, in consultation number V0488-08, has clarified that the partial and temporary assignment of the exploitation rights (for example, for distribution in a specific country during a certain period of time) does not imply a breach of this condition, since the assignor producer retains these rights in his/its assets. On the other hand, the Binding Consultation of the Directorate General for Taxation number 0555-12 has ruled that as long as an EIG retains the exploitation rights, the with- drawal of the investor members prior to the expiry of the 3-year period mentioned above will not imply a breach of the commitment to retain rights as required for benefiting from the allowance. Thus, investors may transfer their sha- res in the EIG before the expiry of the 3-year period. Also, pursuant to the rulings contained in consultations 0555-12 and 0869-11, the co-producers may agree the dis- tribution of revenues in any other proportion than the pro- portion of their respective shares in the copyrights. Having said the above, for the investors’ participation in the EIG not to be considered as a mere financial instrument, the result of the assumption of risks and lead in the production of the work, these must also share in the revenues obtained as a result of the exploitation of their rights. Negative Tax Bases generated by an EIG In addition to the above, as regards cinematographic works, the Corporation Tax Regulations provide a maximum straight-line ratio and a maximum depreciation period for tax purposes (33% and a maximum 6-year period). These ratios may determine that an EIG will also generate nega- tive tax bases that would be transferred to its members as an additional tax benefit in proportion to their respective shares in the EIG. Thus, the EIG members may benefit from the negative tax bases generated by the EIG and offset them against their positive tax bases.


The application of the EIG system and the allowance for canary islands investors: an example An example of the allowance generated by the production of a film could consist in the following financing plan for a feature film:

According to the above example, the production of the feature film will generate a deduction from the corporation tax liability for the amount of 1,900,000 euros. The investor members of the EIG will benefit from this deduction by way of a reduced corporation tax liability. In other words, the profitability of the investment made by the EIG members will be represented to a great extent by a saving in the taxes payable in the accounting period corresponding to the completion of the production. Thus, if the EIG members invest 1,500,000 euros, they will be entitled to apply an allowance of 1,900,000 euros, so that they will be obtaining a profitability of 400,000 euros in a period of probably less than one year. On the other hand, for producers this is a very advantageous method for financing their productions, since the amount con- tributed by the EIG has not necessarily to be repaid to the EIG members, given that these have obtained their return by the application of the tax credits. To this profitability, one should have to add the return obtained from the offsetting, in an applicable case, of negative tax bases, and the return arising from the success in the exploita- tion of the film rights for as long as the EIG retains the owner- ship of the work’s copyrights.


Reserve for investments In the canary islands (RIC) Broadly speaking, the Reserve for Investments in the Canary Islands is a tax incentive allowing the exemption of up to 90% of profits from business activities of establishments located in the Canary Islands that are not distributed and that are transferred to a temporarily restricted reserve. The amounts allotted to the Reserve for Investments in the Ca- nary Islands must be materialized within a period not exceeding three years, counted from the date of accrual of the tax corres- ponding to the accounting period in which these provisions have been made. This materialisation must be made in certain investments, which include, among others, the production of feature and short films and audiovisual fiction, animation or documentary series, as well as the development of shows, when all of these have been made at the Canary Islands. The possibility of materializing the RIC in audiovisual productions has been confirmed by the Consultation to the Directorate General for Taxation number V0509-11. Having said this, it is necessary to point out that the materialization in an audiovisual production is not compatible with the application to the same investment of the film-production investment allowance.


Canary Islands Special Economic Zone (Zec) Finally, it is worth mentioning other tax incentives that film producers may benefit from as a result of their having an establishment in Gran Canaria. The most important one is the Canary Islands Special Zone (ZEC, for its acronym in Spanish), a financial instrument within the framework of the Canary Islands Economic and Tax System, whose purpose is to promote the economic and social development of the Archipelago through the diversification of its production structure. By fulfilling certain requirements, film producers interested in establishing themselves in Gran Canaria may enjoy the following tax benefits: ZEC companies are subject to the Corporation Tax in force in Spain, but at a reduced 4% tax rate (compared with the 25% European average rate). Dividends distributed by affiliated companies that are ZEC companies to their parent companies in other EU member-countries are not subject to withholding thanks to the Parent-Subsidiary directive, as well as dividends distribu- ted to parent companies in countries with which Spain has double taxation agreements. Exemption from taxation on account of Transfer and Stamp Tax.


Summary table

 


Canary islands tax incentives