The US Tax Court recently addressed the tax treatment of litigation financing in Novoselsky v. Commissioner, T.C. Memo. 2020-68 , concluding that advance payments to the taxpayer, a lawyer, with the repayment contingent upon the success of certain litigation, constituted gross income in the year received and not loan proceeds as the taxpayer had argued. The question of how to categorize litigation finance arrangements for tax purposes has long been a subject of debate among practitioners. While each case is fact-specific and litigation finance agreements are not standardized, the court’s opinion nonetheless is informative as it appears to be one of the first times that the Tax Court has addressed the issue and sheds some light on how similar arrangements may be treated by the courts going forward.
In recent years, asset managers have expressed growing interest in the litigation finance industry. Litigation finance generally involves the advancing of funds by a third party (often an investment fund or one of its affiliates) to another party involved in litigation in return for a portion of the reward if the litigation is successful. Litigation financing can take many forms - for example, (i) purchasing all or a portion of a claim directly from the plaintiff for a portion of the potential reward, (ii) advancing funds to law firms to share in contingent fees, or (iii) purchasing debt, equity, or other economic rights in a company that will use the proceeds to finance its own litigation.
The asset and wealth management industry typically focuses on the tax treatment of the party providing the financing (e.g., the investment fund). Considerations may include whether the advance is treated as debt, equity in a partnership, or some other property right to the investor. The tax consequences of this determination will impact timing and character of income, whether payments are subject to US withholding tax, and whether payments are considered income effectively connected to a US trade or business (ECI) or unrelated business taxable income (UBTI). The Tax Court’s ruling in Novoselsky provides insights into accounting for these arrangements by asset managers depending on their particular circumstances.
Novoselsky provides some guidance to asset managers that have expressed a growing interest in litigation finance. Understanding the Tax Court’s analysis in concluding that the advanced payments to the taxpayer did not constitute debt may assist asset managers in determining the tax characterization of existing transactions or structuring future investments.
Asset Management Tax Leader, PwC US