Daily Tax Report: International

INSIGHT: Legal Finance—Solution to Tax Controversy and Compliance Conundrum

Feb. 28, 2019, 11:10 AM

This is not a boring time for tax, legal and finance professionals at multinational companies. Changes in tax laws globally create challenges for bandwidth and budget constrained in-house groups. They also create opportunities for tax executives willing to seize them.

According to Todd Welty, Chair of McDermott Will & Emery’s Tax Controversies Group, ”multinational companies are spending more time and resources focusing on tax controversies in light of changes to tax laws around the world along with the ongoing complexity associated with transfer pricing.”

In the U.S. in particular, multinational companies are dealing with a significant amount of tax uncertainty as a result of the 2017 Tax Cuts and Jobs Act (“TCJA”).

In other jurisdictions, new measures are imposing tax burdens on online commerce and calling into question tax strategies that led many corporations to shift their corporate structures around entities set up in tax favored jurisdictions (e.g., Ireland). These changes create challenges for tax groups at multinational companies as they tackle more audits, assessments, and disputes, all while trying to seize the opportunities created by new tax developments.

There are a number of strategic and tactical solutions that in-house tax, legal and finance teams can deploy in order to respond to the challenges associated with changes driven by the TJCA and other regulatory developments. One of these solutions is legal finance.

Legal finance, which is often referred to as “litigation finance,” is more and more frequently used by law firms and their clients to improve access to justice for small companies and to improve profit & loss ("P&L") results and manage risk for larger multinational companies.

Until recently, legal finance was primarily used to resolve antitrust, intellectual property and contractual disputes, often between an under-capitalized plaintiff and well-capitalized defendant. Its applications, however, are much broader. Forward-looking companies have begun to leverage legal finance in connection with tax controversies in order to:

  • improve their companies’ P&Ls by shifting off balance sheet legal and accounting fees (and other expenses) associated with the relevant tax controversy;
  • create a platform for managing disputes involving common issues across jurisdictions;
  • eliminate obstacles to retaining the strongest possible outside tax counsel and advisers; and
  • leverage the value of refund claims by infusing additional capital into their company to be deployed for, among other things, in-house personnel to deal with the relevant claims, compliance and governance.

Legal Finance

Legal finance involves third parties funding costs in exchange for a share of the benefit that the funded party receives from the funded activity. It can be used by either plaintiffs or defendants to cover fees and expenses, and other costs related to a dispute—including operating costs for organizations involved in a dispute.

The most common form of legal finance involves a funder providing non-recourse funding to a claimant in exchange for a percentage of a judgment or settlement. These arrangements are not loans because if the funded party in the dispute loses, it does not owe any money to the funder.

Increased adoption of legal finance is being driven by, among other things, law firms’ desire to leverage alternative fee arrangements to drive growth, increase profitability and differentiate themselves to clients. For clients, interest in legal finance is driven by not only the high costs associated with using legal counsel, but also to improve earnings. In most cases, legal fees are treated as expenses in a company’s P&L, while funds that a company wins in a dispute are often treated as one-time below the line assets.

Consequently, a company’s profits are negatively impacted by the legal fees that it pays, but rarely are the company’s financial statements positively impacted by the proceeds it receives in connection with a dispute.

While tax controversies—or even compliance—may appear different on their face from these more established ways to use legal finance, they are not. At their hearts, tax controversies and compliance involve spending money on lawyers and advisers to avoid a loss or realize a gain—even if a court is never involved.

While structuring funding agreements may be more straightforward when a company is pursuing a refund claim, there is no reason why legal finance cannot be used in connection with challenging an assessment, or even tax advice that helps a company take better advantage of existing tax rules.

The key to using legal finance in the field of tax is determining what the relevant “upside” is for the company.

In tax refund disputes, this is straightforward, the upside can be measured in terms of the size of the refund obtained.

In assessment disputes, the upside may be the amount by which a company’s tax liability is less than a mutually agreed threshold. If a company takes a reserve on its balance sheet for a potential $500 million liability but the company and legal finance organization believe the actual exposure is only $250 million, the funder would agree to pay the client’s fees and expenses associated with the relevant dispute on a non-recourse basis in exchange for a percentage of the amount by which the client’s ultimate liability is less than $500 million, up to a total savings of $250 million.

In the compliance area, a funder could agree to finance the operations of an in-house tax group or external advisers in exchange for a share of the tax savings realized by a company as a result of the group or advisers’ work.

Does Legal Finance Create any Ethical or Disclosure Issues?

As the legal finance industry has grown, it has gained acceptance from courts and regulators globally. Usury laws do not apply to legal funding because non-recourse arrangements are not loans. Similarly, the concepts of maintenance and champerty have not been an obstacle to legal funding in the U.S. given safe harbors that exist for significant investments involving sophisticated parties and the practice of professional funders of determining that disputes are more likely than not to succeed on the merits before providing funding.

While usury, maintenance and champerty are not commonly issues in tax controversies or compliance, these precedents provide a solid foundation for the ethical use of legal finance in the tax field.

Another issue that has come up is the duty of loyalty that outside counsel has to its clients.

This duty requires counsel to act in a client’s best interests and give the client independent legal advice without interference from third parties. In order to ensure that they do not create problems with respect to the duty of loyalty, legal finance organizations take steps to ensure that they do not control the litigation or otherwise interfere with the attorney-client relationship.

A funder may consider the quality of counsel, litigation strategy, and settlement prospects when making an investment. They do not, however, hire or fire counsel, direct litigation strategy and/or make settlement decisions.

U.S. courts have found that the attorney-client privilege and work product protection are applicable to disclosures made to a legal funder. Similarly, courts have consistently held that a party’s communications with actual or prospective funders are shielded from production based on the attorney work-product doctrine.

While tax authorities may be able to obtain greater access to a company’s internal documents than an adversary would in litigation, the clear trend is to afford communications with funders substantially the same protections provided to communications with lawyers. In any event, reputable funders will always enter into a non-disclosure agreement ("NDA") before discussing confidential information about a matter.

There is an ongoing debate regarding whether a party being funded by a third-party should have to disclose to the other side the terms of the relevant financing arrangement.

Generally, legal finance companies have not been required to disclose the terms of their agreements with their clients. Some have argued that the parties should have to disclose the terms of their agreement to the other side in a dispute. However, such information has generally been deemed irrelevant to the issues in dispute and so beyond the scope of discovery. Disclosure is also generally deemed unfair to the funded party because the other side will know details regarding the funding that its adversary has available to it and the budget for the relevant dispute. The party receiving this information can then deploy tactics that put pressure on available funding and budget.

Planning Points

Multinational organizations that are open to new business models and to evolving their strategies and tactics will be best placed to deal with the challenges and opportunities associated with the changing tax landscape. Legal finance can provide powerful tools to help address the increased costs and lack of bandwidth caused by tax controversies heightened compliance activity.

Specific steps multinational companies can take when investigating legal finance are:

  • identifying amounts at risk, whether these are amounts that have been reserved on the relevant company’s financial statements, identified as potential refunds, or amounts that the company will otherwise have to spend significant amounts on tax counsel and advisers to save;
  • engaging with a funder that has the requisite depth of experience working with multinational companies on complex legal matters globally;
  • working with outside counsel and advisers to determine what a successful outcome will look like; and
  • developing budgets that account for all the resources necessary to obtain a successful outcome.

Scott Mozarsky is Regional Managing Director for North America and Alan Guy is a Managing Director at Vannin Capital.

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