The Hollywood Economist (8 page)

Second, it arranged to have part of the film shot in Britain so that it would qualify for Section 48 tax relief. This allowed it to make a sale-lease-back transaction with the British Lombard Bank through which (on paper only)
Lara Croft: Tomb Raider
was sold to British investors, who collected
a multimillion subsidy from the British government, and then sold it back to Paramount via a lease and option for less than Paramount paid (in effect, giving it a share of the tax-relief subsidy). Through this financial alchemy in Britain, Paramount netted, up front, a cool $12 million. Third, Paramount sold the copyright through Herbert Kloiber’s Tele Munchen Gruppe, to a German tax shelter. Because German law did not require the movie to be shot in Germany, and the copyright transfer was only a temporary artifice, the money paid to Paramount in this complex transaction was truly, as the executive put it, “money-for-nothing.” Through this maneuver, Paramount made another $10.2 million in Germany, which paid the salaries of star Angelina Jolie ($7.5 million) and the rest of the principal cast.

Before the cameras even started rolling, then, Paramount had earned, risk-free, $87 million. For arranging this financial legerdemain Paramount paid about $1.7 million in commissions and fees to middlemen, but that left it with over $85.3 million in the bank. So, its total out-of-pocket cost for the $94-million movie was only $8.7 million.

Since Paramount could be assured of selling the pay-TV rights to its sister company, Showtime, with which it had an output deal, for $8.5
million, it had little, if any, risk. As it turned out, the movie brought into Paramount’s coffers over $100 million from theaters, DVDs, television, and other rights.

Of course, it’s not only Paramount that employs these devices. Every studio uses them to minimize risk. In the case of the
Lord of the Rings
trilogy, New Line covered almost the entire cost by using a combination of German tax shelters, New Zealand subsidies, British subsidies, and pre-sales. The lesson here is that things in Hollywood—and especially numbers—are not what they appear to be, proving, yet again, that in Hollywood, the real art of movies is the art of the deal.

A loophole in Germany’s tax code provided a good portion of the studios’ profits at least up until Germany attempted to close it in 2007. This “money for nothing,” according to the vice presidents at Paramount responsible for arranging these deals, had been earning annually $70 million to $90 million from them. 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. 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 attempts to do by amending its tax code. When you’ve got a golden goose, you don’t want to kill it while it’s still laying eggs.

Although rarely, if ever, discussed outside a corporate inner sanctum, studios make so-called replication output deals in which studios get paid large amounts from Japanese and other foreign manufacturers to support their formats. Consider, for example, Paramount and Dreamworks’ win-win replication deal with Toshiba. In August 2007, in a last desperate effort to prevent its waning HD-DVD format from losing out to Sony’s Blu-ray format, Toshiba offered Paramount and Dreamworks (which Paramount distributes) $150 million to put out the high-definition versions of their movies exclusively as HD-DVD. In such deals,
the DVD manufacturer pays studios up front cash for the right to make its DVDs. Supposedly, it is an advance that the manufacturer eventually gets back from selling the DVDs back to the studio’s video division in much the same way a publisher earns back the advance it gives an author. In this case, Toshiba paid Paramount and Dreamworks a cool $150 million advance even though sales of HD-DVDs were so meager in 2007 that Toshiba was unlikely to ever earn back the entire advance. The wrinkle to the deal was that the studios, Paramount and Dreamworks, agreed not to continue releasing their movies in the rival Blu-ray format.

For Paramount, it was a particularly sweet deal because the payment was booked as a “reduction in cost of goods” for its Home Video division, which meant it did not have to allocate it to any of the titles released on DVD, or share it with writers, directors, stars, other participants, or even equity partners. Then came the real windfall: in March 2008, Toshiba abandoned the HD-DVD format, so the studios got to keep almost all of the $150 million, and then re-released all their movies in the winning Blu-ray format.

Replication output deals go all the way back to the days of videos, when in 1981 Thomas McGrath, a Harvard MBA at Columbia, pioneered
them. They rapidly became part of Hollywood’s invisible money-making apparatus. Paramount, for example, made a quarter of billion dollars from just three deals: $50 million dollars from Toshiba for agreeing to release
Titanic
on DVD in time for Christmas sales, $150 million from Panasonic for agreeing to allow them take over video replication from another manufacturer (Thompson), and $50 million from the law firm of Ziffrin, Brittenham and Circuit City stores for agreeing to support the DIVX format. Since the DIVX format was never launched, Paramount got to keep the money.

The $150 million Toshiba paid Paramount and Dreamworks not to release their titles on Blu-ray was a worthy continuation of this tradition. Such windfalls, even if not visible to the public, are what assure studios a true Hollywood Ending: bottom-line profits even when their films fail at the box office.

Ever since Hollywood established its powerful hold over the global imagination, its studios have sought outside investors to help pay for their movies. The list of these “civilians” stretches
from William Randolph Hearst, Joe Kennedy, and Howard Hughes in the 1920s to Edgar Bronfman, Sr., Mel Simon, Paul Allen, and Philip Anschutz in more recent times. Some such super-rich investors wanted to participate in the selection, casting, and production of the movies. (Hearst, Kennedy, and Hughes, for example, all insisted that their mistresses be given choice roles.) Other civilians, such as the thousands of investors in Disney’s Silver Screen partnerships, sought only the tax-sheltering benefits, but the IRS almost entirely eliminated this loophole by the early 1980s. And some civilians, including hedge funds, actually thought they could make money by negotiating more favorable deals with the studios.

But whatever motives such civilians may have for putting money in Hollywood movies, why do studios want outside funding? When I put the question to a thirty year veteran of studio corporate financing in December 2008, he shot back:

“No journalist who has ever written about movie financing has ever bothered to ask the question: why are the world’s largest and most solvent media companies raising outside capital? Journalists all seem buy, hook, line, sinker, and press release, the line that we [studios] need money.” He noted that it was in a studio’s interest to cry poverty,
if only to get stars and their agents to reduce their demands for compensation, adding, “In my thirty years in this business I have never ceased to be amazed by this gullibility.” Yes, studios can self-finance their entire slate of movies, and, unlike independent producers, they have sufficient revenues flowing from licensing of DVDs and TV rights to meet any film financing needs. The reason for recruiting outside financing is that the studios can make an “asymmetric deal” with an outsider, which means the outside investor gets a smaller share of the total earnings than does the studio on an equal investment of capital. And it is not only journalists who are gullible. Take JP Morgan Chase, which sent out a “teaser” to hedge funds, reading, “Despite compelling economic returns, major film studios are capital constrained and often must seek co-financing arrangements with other studios and other outside sources,” and offered hedge funds “a unique opportunity to participate in the most profitable segment of the motion picture industry.”

Hedge funds brimming with excess capital—at least up until the crash in 2008—made perfect civilian recruits for Hollywood, except that hedge fund managers had neither the expertise nor time to evaluate the prospects of individual films. In
2003, Isaac Palmer, then a young senior vice president at Paramount, came up with a brilliant solution. Studios could offer hedge funds a cut of their internal rate of return. This internal rate of return is not limited to so-called “current production,” or the theatrical releases, on which studios almost always lose money. Rather, the rate subsumes every penny the studio makes from every source including pay-TV, DVDs, licensing to cable and network television, in-flight entertainment, foreign pre-sales, product placement, and toy licensing. So, even in a bad year, such as 2003, when Paramount released enough bombs to get the studio head fired, its internal rate of return was around 15 percent. This return also included the profits from the company’s copyright lease-back sales to foreign tax shelters. (Palmer himself had structured one such deal that netted Paramount $130 million.) Plus, if the studio has a single big breakout movie, as it did in 1999-2000 with
Titanic
, the internal rate of return could leap to as high as 23 to 28 percent.

A safe 15 percent return, with a possible kicker in the event of a hit, proved very attractive to Wall Street. Palmer and his associates at Paramount worked out a deal with Merrill Lynch through which the hedge funds put up 18 percent of the capital for
twenty-six consecutive Paramount movies in 2004 and 2005 through a vehicle called Melrose Investors, which then was extended through 2007. What makes this deal asymmetric is that Paramount also took a 10 percent distribution fee off the top on all the revenues, money which the hedge funds do not share. Since this cut comes from the gross, it makes Paramount, but not the hedge fund, a dollar-one gross player in its own movies.

Other studios had even sweeter or more asymmetric deals with hedge funds. Legendary Pictures, for example, was organized as a vehicle through which hedge funds, such as AIG Direct Investments and Bank of America Capital Investors, could sink a half-billion dollars into Warner Bros. movies. But, unlike the Melrose Partners deal, the Legendary Pictures investors do not participate in the entire slate of Warner Bros. movies, which means that they do not really participate in the internal rate of return.

In its asymmetric deals with Wall Street studios enhance their own returns by getting a distribution fee on their investors’ share of the revenues. And remain true to the Hollywood tradition of giving civilian investors the short end of the stick.

In the golden era of the studio system, a studio mainly confined its principal photography to its own highly-efficient sound stages and back lots, where it could deploy its contract stars and technicians, and had whatever exotic material was necessary shot by a traveling second unit. Nowadays, movies are shot all over the world, but in scouting locations, producers are not seeking the most authentic settings or spectacular production values. The lure is government subsidies. As one producer put it, movies, like ladies of the night, go where the money is. Such subsidies can finance up to a large share of the below-the-line budget through a series of maneuvers in which a movie first qualifies for tax credits by employing local actors and technicians, then selling those credits.

Hence the appeal of Canada. The Canadian federal government provides foreign producers with a subsidy, called the Film Production Services Tax Credit, which in 2008 equaled 16 percent of Canadian labor costs. In addition, British Columbia offers an additional 18 percent rebate on labor from that province. Finally, there is a 20 percent break on digital effects, if they are done in Canada.
In order to qualify for this tax credit—which the producer sells through a Canadian partner—either the director or the screenwriter and one of the two highest paid actors must be Canadian, which might partly explain the demand for Canadian actresses, such as Alex Johnson, the star of
Final Destination 3
.

Heeding the siren call of subsidies, Hollywood moved north over the last decade, outsourcing to Canada no fewer than 1,500 movies and television productions. Producers found Vancouver could double for middle America, Toronto could stand in for New York City (especially if the director avoids wide shots), and Calgary makes for a great American West. At times, some script adjustments were required to accommodate the cold reality of the North. For example, in
Final Destination
3, which was filmed in British Columbia, the climactic attack was supposed to occur during an outdoor party on the Fourth of July but since it was not feasible to have actors wear summery clothes during Vancouver’s chilly spring, the holiday was changed to the town’s tricentennial celebration. But for Hollywood’s illusion-makers, who have much experience in geographically deluding audiences, such adjustments are worthwhile, especially if they finance one third or so of the budget with a depressed currency,
the plummeting Canadian loonie. As a result of this location shopping, Canada has emerged as a Hollywood stand-in for America.