Chapter excerpt: Tax

Jared Wade. Partner, Vault Group LLP
Walter Mansfield. Partner, Vault Group LLP
David Tran. Tax Director, BDO UK LLP
John Middlemass. Tax Manager, BDO UK LLP

Table of contents

• The devil is in the detail
• UK tax considerations
• US tax considerations

Tax can be an afterthought in the process of entering litigation proceedings and arranging litigation funding, with all parties focused on working towards a successful case outcome and receiving their share of the eventual compensation or damages. However, the wide-ranging tax rules can be complex, and their interpretation and application can result in unexpected tax consequences, such as a lower net return than originally forecast upon entering the litigation funding arrangement and also possibly having to pay tax before the conclusion of the case.

The relative newness of the litigation finance industry relative to other more familiar and well-established commercial areas produces a wide gap between experience and theory. This chapter will help bridge that gap and seeks to give a flavour of the key tax themes from a UK and US tax perspective with potential pitfalls to watch out for.

THE DEVIL IS IN THE DETAIL
Each funding agreement is based on a unique and very specific set of facts and details. As such, there is no one-size-fits-all approach to funding arrangements, so careful analysis and drafting of the agreement is key.¹

Funding agreements may provide for a regular return on the funding, akin to interest payments, but most will take a speculative approach with income realised based on the success of the underlying case. Regardless of the form of the funding agreement, managing UK and US tax considerations must be a focal point from the start.

A particular area of debate or uncertainty in the taxation of litigation funding is often how to characterise the nature of the agreement in order to apply the established UK and US tax principles, which are generally applied to the provision of services, or are related to debt and equity instruments.

These principles will often dictate:
• What is the nature of the return (income or capital)?
• How is the return taxed, and at what rates?
• When is the return taxable?

Key tax themes

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UK TAX CONSIDERATIONS

This section of the chapter focuses on the UK tax considerations for UK litigation funding arrangements that involve one or more of:

• a corporate UK litigation funder;
• a UK claimant receiving external funding for litigation; or
• a UK law firm involved in the litigation.

Firstly, it should be pointed out that litigation funding is a relatively new concept in the UK tax landscape and there is no specific UK tax legislation, guidance or established case law.

There could be additional complexity where there are cross-border litigation funding arrangements, either outbound funding from the UK funder or UK claimants receiving funding from abroad. This book does not attempt to give details of all of the international tax aspects of litigation funding.

Ultimately, the tax consequences for each party will depend on the legal construct and drafting of the litigation funding agreement (LFA) and the arrangements between all parties, and each case could be different.

The following sections give an overview of the key UK tax themes and points to consider before entering into a litigation funding arrangement, in the eyes of each of the above parties.

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US TAX CONSIDERATIONS

As is the case in the UK, litigation funding is also a developing area within US federal income tax law.⁵ Within this section, we will focus on certain issues central to the application of US income tax law to a litigation funding arrangement, described primarily from the perspective of the funder.

The main issues
The topics discussed below summarise basic tax considerations primarily from the perspective of the funder, but at times this section will also highlight issues relevant to the other affected parties. The key areas of focus throughout will be: (1) the basic US income tax issues when entering into the funding arrangement, (2) the tax characterisation of the funder for US federal income tax purposes, (3) the differences in character of income in relation to the funding agreement, (4) the timing of inclusion of income in relation to the funding agreement, including specific US tax considerations when using a prepaid forward contract, and (5) issues that may arise in a cross-border arrangement.

A general note regarding the parties to the funding agreement
While this section focuses primarily on the US income tax considerations to the funder, of equal importance is the application of US income tax law in determining the treatment of the other affected parties, which must be taken into consideration when drafting the funding agreement. Such other affected parties include not only the claimant in a given case, but may also, depending on the arrangement, include a third-party law firm, herein generally referred to collectively as the ‘counterparty’. For purposes of this section, it is generally assumed that the funding is of a US-based counterparty but considers a funder that may or may not have a presence in the United States.

The US tax characterisation of the funding agreement
A detailed analysis of the terms of the funding agreement⁶ is necessary to determine its characterisation for US income tax purposes. It is a critical first step and essential to determining whether any income to a US tax-relevant funder is to be taxed at ordinary income tax rates or at preferential capital gains rates. For an affected individual US taxpayer, this rate differential can be up to 17 per cent (excluding the net investment income tax imposed under IRC section 1411).

LFAs may be constructed as a loan with an interest-like return on the advance or more like a speculative investment through which the funder is compensated only in the event that the claimant’s case is successful. The latter arrangement, generally offering more significant potential returns to the funder, is more common and typically will be structured such that the funding arrangement should be regarded as an acquisition of a right to share in any proceeds from the case in exchange for the funding. We consider first, however, the treatment of a funding arrangement as a loan.

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¹ See further at chapter 6.

⁵ Unless otherwise noted, references to US income tax law are to US federal income tax only and are not intended to cover state, local, or other non-US tax of any nature. All references to ‘section’ are to the Internal Revenue Code (IRC) of 1986, as amended, or the regulations (final, proposed or temporary) thereunder, both as amended up to the date of publication of this book.

⁶ See also chapter 6.

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