The UK Chancellor of the Exchequer's annual budget has been watched with trepidation by the film industry in recent years. The biggest change was the dramatic overhaul of the tax system that ended the sale-and-leaseback era.

But in hindsight Gordon Brown, now the prime minister, made perhaps the most significant gesture of permanent change in last year's Budget. In it, he closed a tax loophole that had allowed the offsetting by investment partnerships of expected losses on film investment against other income in tax returns.

Experts estimate the scheme - known as sideways loss relief - might have been worth $4bn in investment in film.

But it is not the loss of potential finance that will be remembered as the most significant part of the story.

The Budget spelled out an explicit shift in UK film finance from support for investors to producers - or a transfer of power to film-makers from the financial middle-men.

The sale-and-leaseback changes may have set the agenda but the last hurrah of significant tax-avoidance funding for film was perhaps a turning point from which we can look at the current progress of the industry.

From that moment on, the industry's fortunes would be tied to a tax credit which, for all its flaws, was at least stable and transparent.

Understandably, industry reaction at the time was rather more guarded than that of the government. While many could see the logic - or even the inevitability - of the changes, what everyone agreed on was that a significant source of financing had disappeared with little warning.

A year on, what is immediately apparent is that the more doom-laden predictions of wipeout have not materialised.

The 2007 production figures released by the UK Film Council show feature-film production in the UK dropped by 15% overall, slipping from $1.7bn (£855m) in 2006 to $1.46bn (£723m). Inward investment from international film-makers also fell by 13.9% to $1bn (£506m).

But indigenous production numbers were up to 58 from 54 in 2006, although the 2007 spend was down slightly at $280m (£141m) from $300m (£153m) the previous year.

The only area where a decline has been unequivocal is co-productions, which dropped by 44%, to 28 in 2007, compared with 53 the previous year. As a result, the spend collapsed to $145m (£73.8m) from $225m (£112m) in 2006.

While disappointing, it is hard to interpret the drop as the black hole in production envisaged by some.

Quality counts

Indeed, there is a strong argument the UK was effectively over-producing low-quality films made to soak up equity from sources such as tax-relief schemes. Such an approach has been out of kilter with international markets that increasingly demand quality that can sell. That is a challenge to the way producers do business.

"There is an increasingly strong sense that equity investors want to know they will get their money back," says Kevin Loader, who will this year complete Brideshead Revisited and Good and is enjoying success in Spain with The Oxford Murders. "I'd say there was a more commercially rigorous wind blowing through the industry at the moment."

And that is translating into fewer films at a certain level, as Loader acknowledges. "I do get a sense there were a number of movies being made, around the £1.5m ($3m) mark, that didn't really merit distribution," he says. "However, there are models for micro-budget movies available and there are probably different movies being made at that level now."

Industry attitudes

The UK Film Council and the government implicitly argued that case last year when the tax loophole was closed. What the industry needed was a tight but transparent financial regime aimed specifically at making quality films, they said.

Sustainable business required the firm foundations of a stable tax credit, not whether smart accountants were able to exploit a tax loophole before the government spotted what they were up to.

The film tax credit hit the statute books in January 2007 and was expected to provide about $242m (£120m) in support to the film industry.

John Woodward, chief executive of the UK Film Council, pointed out at the time: "It is still early days, but feedback from the industry is that the new tax credit is working more effectively for indigenous and inward investment films, because it has been simplified, provides certainty to the film-maker and the benefit goes directly to them. For those reasons, it appears to be less likely to be misused."

The new minister of state for culture, creative industries and tourism, Margaret Hodge, agrees. "What the UK film industry needs is a period of stability, which can never be achieved with tax-avoidance schemes. We've had a very positive response from the industry," she says. And, to an extent, she has a point.

Rebecca O'Brien of Sixteen Films, Ken Loach's longtime producer, says: "I never felt that sideways loss relief going was a bad thing. I see it as a real change for the good. There is clarity now, no room for confusion. There was always a danger that the carpet would be pulled out from under. And as a producer, you were never entirely sure of the legality."

In the long run, the industry may be grateful not to rely on investment schemes. Given the credit crunch, the investment climate has become unstable. First, of course, there may be less money looking for high-risk, high-return deals. Second, every government in the world during a recession is going to be looking at tax avoidance with a far keener eye. And it may be that the best bet for a producer going to the bank is the certainty of a stable tax credit.

A big blow

But many producers say they are feeling the pinch. For Alex Brown, a partner at the UK production company Studio 8, an era with such heavy reliance on a single tax credit has not been easy.

"Before, we could look at up to 45% of relief on a film," he said. "Now, you would be lucky to receive 18% on a 100% British film. It's been a big blow."

It is not just a question of finance. Sale and leaseback and the intended sideways loss relief were financial mechanisms but the tax credit is tied to a series of cultural tests that restrict where a film can be made.

Mike Downey, of Film and Music Entertainment Limited, suggests producers have started to look abroad and to squeeze finance out of new sources. "The most popular new model is simply getting cornerstone finance out of the UK and shooting elsewhere, hence the tumbling statistics. Next up is EIS (Enterprise Investment Schemes, offering tax breaks to smaller investors), which work to an extent for low-budget films.

"But for British films of scope and vision with global cosmopolitan scale that aren't set in the UK, we have to look elsewhere for the backbone of our financing."

One certainty is that there is no easy money out there. With television pre-sales collapsing, a global credit crunch and fears of a recession, everyone is chasing hard for finance.

Fiona Hotston Moore, managing partner and head of media at accountant/consultant Mazars, says: "As a firm and across the UK, we have noticed a lot more producers chasing money directly, ringing intermediaries and professionals such as ourselves to see if we can direct our clients and contacts to them.

"The quality of the projects is far higher than two or three years ago when such approaches would have been on fringe and small-budget projects."

Some of those fringe projects may simply have been squeezed out of existence. As Downey puts it: "It's brought about stability in that independent production levels have stabilised so much they have practically ground to a halt.

"The tax credits have been great news for the US studios and for the publicly owned British studios. Production levels in that sector have been maintained and this is great for the investors in those public companies. For now ..."

International contraction

But perhaps the most serious question is whether the tax credit is drawn too tight for an international market.

Several industry sources are convinced the negative impact on co-productions is not a short-term blip but an intrinsic failure of a system too tightly wrapped around cultural tests.

One common criticism is that it is not as efficient as the former sale-and-leaseback scheme in providing volume and mixed portfolios via minority partnership stakes in European co-productions.

As Studio 8's Brown points out: "For co-productions, the tax credit is not a well thought-out plan at all. It's just not interesting to anyone to do a co-production here any more. There's no real incentive. The phone has changed from ringing constantly to outgoing calls only."

Nor is the negative fallout for the UK industry limited to co-production, according to Mike Downey. "There are post-production facilities, effects houses and labs that have been powerfully hurt by the demise of co-productions in this country," says Downey.

"I know a handful that have closed already, or are on the point of closing their doors. There is a level of price dumping going on in order to keep up some volume of business to keep doors open, but this is a short-term route to disaster."

The Film Council admits that when choices had to be made between inward investment, core British film or co-production, it was co-production that lost out. The government has already asked the Film Council to re-evaluate the tax credit to examine its impact on co-productions. But although the problem is clear, the solution is less so.

While the industry is being fairly vocal on the need to address the co-production issue, few workable solutions have been identified as yet.

Consumer use

Falling co-production is not the only international issue stemming from the new film-tax credit - the 'use and consume' rule is also causing problems.

Under current rules, only costs used and consumed in the UK are eligible. The result is that a tax credit intended to strengthen the position of the UK industry both within Europe and on the international stage could undermine it in some key areas.

For example, costs incurred on 'UK films' shooting outside the country are ineligible for the credit, even if the production uses a full UK crew and equipment. And in a policy climate that strongly promotes cultural diversity and identity, the problem has cultural as well as logistical resonance.

O'Brien says: "It is the nature of our island that a lot of our stories play outside of that island." Her award-winning film The Wind That Shakes The Barley is a case in point.

As she points out: "This is a very British story that won the Palme d'Or for the UK, but it wouldn't have been eligible (for the tax credit) except for post-production."

Of course, the flip side is that foreign crews working in Britain are now regarded as eligible costs under the credit. While this may be very attractive for inward investment, there is an argument that it does nothing to nurture or promote the domestic skills base.

As Martin Spence, assistant general secretary of the Broadcasting Entertainment Cinematic and Theatre Union (Bectu), says: "We are in a perverse situation. On the one hand, there is a lot of effort and money going into the training of UK film professionals. But on the other hand, under the rules governing support for British film production, it's possible to make a film with 100% of the available tax credit with a crew that comes from outside of Europe."

For all those concerns, one year on from the closing of the tax loophole, few people are mourning the loss of sideways relief.

The tax credit is widely perceived as heading in the right direction but even its strongest supporters acknowledge it is far from perfect.

It is clear that films are still being made, sources of finance being found and the disaster scenario that was touted only a year ago has failed to materialise. A number of factors are taking on new significance, though - decisions about whether to work internationally, the availability of increased private equity and the role of 'soft money'.

From here to where'

This is still very much a bedding-in period and, as Mazars' Hotston Moore points out, the desire to invest in film is still very much alive. "Interest by individuals has remained strong, albeit with the demise of sideways loss relief for partnerships," she says.

However, the removal of tax loopholes and the switch of focus to the producer seems to indicate a change in the underlying attitude to the long-term financing of movies rather than a radical new approach.

The next step' Well, many in the industry were hoping Chancellor Alistair Darling would follow the line of promoting stability and confidence and resist the urge to generate any more confusion with major changes in this week's Budget.

Since this week's closed loophole only affects a very specific set of film investors, most producers should be relieved.

And looking ahead, the Film Council's new consultation about the film tax-credit regime could help iron out the wrinkles in the current system, but any changes are likely to have to wait until the next Budget in March 2009 at least.

2007 figures
Total spent on making films in the UK
2007: $1.46bn (£723m)
2006: $1.73bn (£855m)
Inward investment from international film-makers
2007: $1.03bn (£508m)
2006: $1.19bn (£590m)
Co-production spend
2007: $149m (£73.8m)
2006: $226m (£112m)
No inward co-production in 2007
UK feature films: 58
Inward investment: 26
UK co-productions: 28
Total feature films: 112
Source: UK Film Council

The 2008 Budget this week saw Chancellor Alistair Darling make further steps to close the sideways loss relief loophole.
The clampdown now reaches individuals acting as sole traders and claiming tax relief without being able to prove that it was a serious part of their weekly work.
Influential commentator Martin Churchill, editor of Tax Efficient Review, believes plans submitted were worth $1.6bn-$2bn. "If the Treasury had not taken action, it would have encouraged more to take up the scheme," he said.
The sole-trader schemes were mostly being used to buy territory rights for US and some UK films.