Many actors, including leading stars such as Shah Rukh Khan, Amitabh Bachchan and Aamir Khan, have set up their own production houses, entirely for commercial efficiency. But this has brought to the fore many challenges on the tax front.

Payments made to actors' production houses are often contested by the tax authorities. There have been instances where tax authorities have denied a deduction of such payments from the business profits in the hands of the payer - the producer or co-producer.

This means, such expenditure is added back to the income of the producer or that of his business entity, which inflates the net profits and consequently results in a higher tax burden.

A recent ruling by the Income-Tax Appellate Tribunal (ITAT) brings respite from this tax challenge. The Mumbai bench of the ITAT has allowed a deduction of Rs 1.52 crore for Karan Johar's Dharma Productions. This business entity had made these payments to Red Chillies Entertainments Pvt Limited (RECL), founded by actor Shah Rukh Khan.

These payments were towards joint production of the film Kaal - a Bollywood horror film released in April 2005. Under the agreement between the entities owned by Johar and Khan, the profits were to be shared equally and their contractual obligations and responsibilities were clearly defined.

For instance, in addition to creative, technical and marketing input, RCEPL was also to provide use of cinematographic equipment. Further, Kaal was also released under a joint banner.

One of the main objections raised by the tax authorities was that the services were rendered by Khan in his personal capacity. Thus, as no service was rendered by RCEL, the payments made to it by Dharma Productions were not an 'admissible business deduction' for the latter.

The ITAT did not agree with this view. It held that these services rendered by RECL were creative in nature and required personal expertise and talent. It also observed that Khan had also performed the title song in the film for which no separate payment was made to him.

"The only inference that can be drawn from the given facts and circumstances is that the services rendered by Khan are on behalf of RCEL and under the contractual obligation," the ITAT concluded.

Rakesh Jariwala, EY partner specializing in the entertainment sector, states, "With participation agreements gaining popularity in Bollywood, the ITAT has given a significant ruling as it recognizes that a creative services company (RCEL in this case) is entitled to arrange and provide services for a project as per the terms of the contractual agreement."

Gowree Gokhale, partner at law firm Nishith Desai Associates, explains, "If actors charged sky-high fees, it was not commercially feasible as not all films do well. On the other hand, if an actor charged moderate fees and the film was a huge success, he lost out. In this backdrop, business-savvy actors began to set up their own production companies and entered into co-production deals where they owned part of the intellectual property in the film and could also claim their share of back-end profits.

There are variations to such business models - such as revenue share, profit share and service fee models - and the tax implications accordingly differ. Proper structuring of the business model and agreement helps deal with tax challenges."