The Magic Of Studio Financing

Last week I was invited to be part of a discussion panel at the Silicon Valley Film Festival. The subject of the panel was new technologies in  independent film making. One of the off topic questions that I am invariably asked at these types of gatherings. Is why do studios persist in making 300 million dollar tent pole films (block busters) They could just as easily make thirty 10 million dollar films or sixty 5 million dollar films? Why bet the studios financial solvency on one roll of the dice?

As paradoxical and absurd as it sounds, it's cheaper for a Hollywood studio to make a big-budget action movie than to make a shoestring art film like Sideways. Consider Paramount's 2001 action flick Lara Croft: Tomb Raider. On paper, Tomb Raider's budget was $94 million. In fact, the entire movie cost Paramount less than $7 million. How did the studio collect over $87 million before cameras started rolling?

First, they used the German tax-shelter gambit. Loopholes in Germany's tax code are responsible for a good portion of Paramount's profits—an estimated $70 million to $90 million in 2003 alone. Best of all, there's no risk or cost for the studio (other than legal fees)

Here's how it works: Germany allows investors in German-owned film ventures to take an immediate tax deduction on their film investments, even if the film they're investing in has not yet gone into production. If a German wants to defer a tax bill to a more convenient time, a good way to do it is by investing in a future movie. The beauty of the German laws as far as Hollywood is concerned is that, unlike the tax laws in other countries, they don't require that films be shot locally or employ local personnel. German law simply requires that the film be produced by a German company that owns its copyright and shares in its future profits. This requisite presents no obstacle for studio lawyers.

The Hollywood studio starts by arranging on paper to sell the film's copyright to a German company. Then, they immediately lease the movie back—with an option to repurchase it later. At this point, a German company appears to own the movie. The Germans then sign a "production service agreement" and a "distribution service agreement" with the studio that limits their responsibility to token—and temporary—ownership.

For the privilege of fake ownership, the Germans pay the studio about 10 percent more than they'll eventually get back in lease and option payments. For the studio, that extra 10 percent is instant profit. It is truly, as one Paramount executive told me, "money for nothing." In the case of Lara Croft: Tomb Raider, Paramount sold the copyright to a group of German investors for $94 million through Tele-München Gruppe, a company headed by German mogul Herbert Kloiber. Paramount then repurchased the film for $83.8 million in lease and option payments. The studio's $10.2 million windfall paid the salaries of star Angelina Jolie ($7.5 million) and the rest of the principal cast. 

Paramount made some more preproduction cash by taking advantage of the British government's largesse. To qualify for Section 48 tax relief in Britain, the movie had to include some scenes filmed in Britain and employ a couple of British actors. Given Lara Croft's peripatetic plot, neither condition presented an artistic problem. Again, Paramount entered into a complex sale-leaseback transaction, this time with Britain's Lombard Bank. Through this legal legerdemain, the studio netted, up front, another $12 million—enough to pay for the director and script.

To pay for most of the rest of the movie, Paramount sold distribution rights in six countries where the Tomb Raider video games were a big hit with teenage boys. These pre-sales in Japan, Britain, France, Germany, Italy, and Spain brought in another $65 million.

Through this triple play, Paramount earned a grand total of $87.2 million. The remaining budget—less than $7 million—would be covered by licensing the film's U.S. pay-television rights to Showtime (a network owned by Paramount's corporate parent, Viacom). At no cost to its treasury, Paramount launched a potential franchise—don't forget that sequels can be financed with the same "risk management" techniques.

Why couldn't Sideways, which cost just $16 million, use these tricks to pay off its much smaller budget? Because the international financing game favors big-budget movies with international appeal. Even if a $16 million production did entice a German tax shelter for some reason, the lawyers' bill for arranging the transaction would eat up most of the leaseback skim. A movie like Sideways, which is artistically grounded in California, would also have a hard time qualifying for the British tax subsidy. And finally, Sideways lacked the advance name recognition that's required to ring up large pre-sales in foreign markets.

Of course, it's not only Paramount that employs these devices—every studio uses them to minimize risk. Remember all those stories about how New Line was betting its entire future on the Lord of the Rings trilogy? Not quite. New Line covered almost the entire cost by using German tax shelters, New Zealand subsidies, and pre-sales. If studio executives don't crow in public about such coups, it's probably out of fear that such publicity will induce governments to stiffen their rules—as, for example, Germany periodically does mess around with its tax code. When you've got a golden goose, you don't want to kill it while it's still laying eggs. Unfortunately,  the German tax shelter turned out to be a golden goose for Hollywood studios, it didn't lay golden eggs for the German filmmakers. American movies have increased their share of the German box office, accounting for more than 85 percent of it last year. So politicians find little justification to keep this loophole in the tax code. Hollywood, alas, will now have to find other equally imaginative ways to supplement its earnings.