Australia's new 12.5% tax offset is designed to encourage footloose productions to spend more of their budgets in Australia. Sandy George reportsIt was an e-mail that was never meant to be made public. It described a Los Angeles telephone call, now 18 months ago, from angry Warner Bros executive Bob Fisher to Australia's film commissioner David Pratt, complaining that Australian investors were not being allowed the tax deductions they had claimed from the Australian Tax Office (ATO) for putting money into Warner Bros' Red Planet.

Under Division 10B of the tax legislation, investors can get a 100% tax deduction over two years on films made wholly or substantially in Australia. Put simply, under the legislation - which was never intended for the film industry - an investment of $28,000 (a$50,000) means an investor can reduce his or her taxable income by $14,000 in that financial year and again in the next.

But the ATO decided to clamp down on the use of 10B as a tax shelter by film investors, many of whom borrowed the money in order to invest, as the investments were not genuinely at risk, as demanded by the legislation.

Rather, the arrangements were contrived to cover the production costs of non-Australian film-makers. The ATO's actions meant that Australia no longer offered a reliable financial incentive for offshore producers.

Fisher thought the ATO had previously allowed very similar arrangements and saw its actions as an about-turn. "You can forget the studios shooting major features in Australia," he is reputed to have said, promising to warn off all the US studios. Soon after, it was confirmed that investors' claims relating to 20th Century Fox's Moulin Rouge had also been refused.

Suddenly US executives were arriving to fast-talk government ministers, key service company representatives were lobbying anyone who would listen, the media was awash with stories about how the new romance with the US was over, and state governments were issuing derogatory statements about Australia's ruling Coalition government.

The problem was fixed with the announcement, in September 2001, that an entirely different incentive would be introduced: a straightforward rebate on the Australian expenditure of a film production.

Put simply, if a producer can prove $8.4m-$28m (a$15m-a$50m) has been spent in Australia making a film, providing that expenditure represents at least 70% of the budget, they can apply to have a fixed 12.5% of that expenditure paid back, shaving approximately 10% from the production budget.

The 70% condition encourages as much spending in Australia as possible, including on post-production work, but does not apply where the Australian expenditure exceeds $28m. The incentive is described as a 'tax offset' because it effectively offsets the taxes paid as part of Australia wages and services. But in effect it is a tax rebate.

Michael Lake, executive vice president of worldwide feature production for Village Roadshow, which has a production joint venture with Warner Bros, told a recent gathering of international film commissioners that Australia was "very smart" to have chosen this incentive because of its ease of operation and certainty.

Lake still has overall responsibility for filling the eight sound stages at the Warner Roadshow Movie World Studios, despite relocating to Los Angeles several years ago, so he could be seen as flying the flag. But he has also watched nearly three-quarters of the finished films under the 40-picture joint venture access incentives from around the world - including Australia's 10B.

Since the 12.5% offset was introduced, the Los Angeles office of marketing organisation AusFilm, the best gateway for information and referrals, has had a 30% increase in enquiries. The two Matrix sequels and the Miramax World War II drama, The Great Raid, all of which recently wrapped, are sure to claim the offset, as will Revolution Pictures, Columbia and Universal's Peter Pan, which shoots until February.

But as the rebate cannot be claimed until a film is finished, the first confidential application is only now being considered and the scheme has yet to be fully tested. The Great Raid producer Marty Katz says some anomalies are still to be addressed. For example, airfares to Australia qualify if bought locally but not the return trip.

"The story demanded sub-tropical locations, crew good enough to work on this scale and a mixed cast of Filipinos, Japanese, and Caucasian and ethnic blends," says Katz of The Great Raid, which spent more than $28m locally so escapes the 70% rule.

"Hawaii was too expensive and the Philippines unsafe after September 11. Australia was more expensive on paper than Thailand, but the tax offset equalised costs."

Applicants for the tax offset must be Australian residents or permanently established in Australia. Service companies such as Village Roadshow Production Services, which Katz used on The Great Raid, fulfil this criteria. Applications are made to the Department of Communications, Information Technology and the Arts for the 12.5% rebate on all Australian expenditure. According to government projections, $30m is expected to be returned to productions worth $475m in 2005-2006.

The new incentive has a predictability not present in 10B, and does not require finding local tax-driven investors or specialist tax lawyers. Film producers can still access 10B but only instead of the offset. However, the offset cannot be used where budgets contain direct Australian government subsidies, such as those available through the Film Finance Corporation (FFC).

As most local productions access FFC subsidies, there is some resentment about this from local producers. However, few would be able to spend the minimum $8.4m required in the first place.

But local producers are well catered for in terms of other subsidies. As producer Jonathan Shteinman puts it: "The only money in Australia that is not soft money is that which the distributor spends they know they won't get back from a television sale."

While this is a slight exaggeration, the sentiment is true: Australia would not have a film industry without taxpayers' money and local content quotas for broadcasters.

While its mandate is predominantly cultural, non-Australian film-makers can access FFC finance using one of the government-to-government, co-production agreements that are in place with Canada, France, Germany, Ireland, Israel, Italy, the UK and Vietnam. Others can join in via three-way arrangements with these countries or by striking new deals.

There are also smaller, state-based incentives. One fund entices footloose productions to shoot in New South Wales, for example, and a second encourages producers to use rural areas. Productions shooting at Sydney's Fox Studios can claim payroll tax rebates and an exemption operates in South Australia. Queensland and Victoria waive location fees in their business districts and offer other incentives.

Even in quiet Western Australia, moves are afoot to introduce formal incentives, although Jeremy Bean, of state agency ScreenWest, says arrangements could be made for individual films now if the benefits to the state are demonstrable.

The Australian economy was once driven by agriculture, but now many rural communities are struggling, and the film industry is proving an unlikely saviour. By shooting in rural Victoria for at least a week, a producer is eligible for up to $56,000, providing expenditure and local employment levels satisfy a government and film committee. This year, only the $22.3m UK-Australia co-production The Kelly Gang has successfully applied to the Regional Film Location Assistance Fund (Rlaf), which is worth $280,000 a year. It also accessed the Melbourne Film Office's (MFO) other, more significant, pot of money, the $1.1m Production Investment Attraction Fund (Piaf).

While expenditure and employment also determine the Piaf, only genuinely footloose productions are eligible and at least $1.9m, or 70%, of the budget must be spent in the state. MFO director Louisa Coppel has often used the fund to attract post-production, in which case at least three companies must benefit. Australian films The Wannabes (production) and Bad Eggs, and Asian titles So Close and Big Shot's Funeral (post-production) are this year's other beneficiaries.

Unlike the Rlaf, there are no prescribed per-film limits. While Coppel agrees Queensland's rebate system offers certainty because all films automatically get them once they reach expenditure minimums, her funds have advantages: "We are not bound by a rigid percentage rebate and that gives us the flexibility to go very hard after a project," she says. "This might happen if production was quiet in Victoria, for example."

Payroll tax, local cast and crew salary rebates, and discounted interns are all on offer to productions that shoot in Queensland. All payroll tax is refunded as long as total expenditure in the state is at least $1.9m and the salary rebate - which equates to 8%-10% of wages - is capped at $168,000 for expenditure over $8.4m. The Pacific Film and Television Commission also meets 80% of the cost of interns, a buyer/dresser and an assistant director. These are extraneous roles that would not normally be filled by most Australian productions, the aim being always to employ as many people as possible locally. There are also discounted police and fire charges.