Litigation Funding as an Investment for Americans in Britain
Litigation funding has moved from a niche corner of the legal market into the portfolios of wealthy private investors, and London is one of the busiest centres for it in the world. An investor pays some or all of a claimant's legal costs and, if the case succeeds, receives a multiple of the capital or a share of the damages. The returns are uncorrelated with equity markets and can be spectacular. For an American living in Britain, however, the tax answer is far less clear than the investment case.
Neither country has written rules for the individual funder. America has never issued guidance on whether a funder's profit is capital gain or ordinary income, and Congress came within weeks of imposing a 40.8 per cent tax on it in 2025. Britain has no bespoke rules either, and a Supreme Court decision has left many funding agreements of uncertain enforceability. Consequently, the same successful case can be taxed on different principles in each country, and the foreign tax credit that normally reconciles the two can fail.
At TaxYork we prepare the returns of hedge fund professionals, business owners and private investors in London who hold funding positions alongside conventional portfolios. In our experience, the damage is rarely caused by the investment. Instead, it comes from an American return that labels a litigation funding profit as ordinary income from an American lawsuit, which is the most expensive characterisation available.
Why Litigation Funding Returns Are Hard to Tax
Most investment income fits an existing category. Interest comes from a loan, dividends from shares, and gains from selling property. Litigation funding fits none of them cleanly. The funder usually has no right to repayment if the case fails, so it is not a conventional loan. Equally, the funder owns no share in the claimant, so it is not equity. Therefore, both tax systems must decide which category the arrangement most resembles, and they approach that question with different tools.
Furthermore, the return is contingent on a legal outcome that may take five years or more to arrive. That long, uncertain holding period magnifies every timing and characterisation mismatch between the two systems. Additionally, a portfolio of cases produces both spectacular gains and total losses, and the two countries treat those losses very differently.
The Structures on Offer
Private investors generally meet litigation funding in three forms. The first is a direct participation in a single case or a small portfolio, often syndicated by a specialist funder. The second is an interest in a closed-ended litigation finance fund. The third is shares in a listed funder. Each form carries a distinct American and British treatment, so the structure you hold matters as much as the cases themselves.
How the IRS Characterises a Litigation Funding Return
American treatment turns on how the agreement is drafted and on how its economic substance looks to the IRS. There is no statute, regulation or ruling that answers the question directly.
Loan, Equity or Prepaid Forward Contract
Funders in America draft their agreements in one of three ways. A loan produces interest, taxed as ordinary income. An equity-style participation produces a share of the proceeds, whose character depends on the underlying claim. A prepaid forward contract, the most common modern form, treats the funder as paying in advance for a future contingent payment, and is drafted to produce capital gain under section 1234A, which treats the settlement or termination of rights in a capital asset as a sale or exchange.
The drafting choice is not decisive, but it matters. Accordingly, before you invest, you should know which form the agreement takes and whether the sponsor has taken a formal tax position on it. Many sponsors of litigation funding syndicates never do, leaving each investor to choose a position alone.
Novoselsky and Why Contingent Repayment Is Not a Loan
The Tax Court considered contingent litigation advances in Novoselsky in 2020. An attorney received money from backers to fund class actions, with repayment due only if the cases succeeded. The court held that the advances were not loans, because an obligation that depends entirely on the litigation outcome is not a genuine debt. That case concerned the recipient, not the funder. Nevertheless, its reasoning cuts against treating most litigation funding as a loan from the funder's side too, which removes the interest characterisation for most agreements.
Origin of the Claim and the Ordinary Income Risk
The risk for the investor lies in the judge-made doctrines. Under the origin of the claim doctrine, a recovery takes the character of what it replaces, so damages for lost profits are ordinary income in the claimant's hands. The IRS can argue that a funder's share of those damages is similarly ordinary. Moreover, the substitute for ordinary income doctrine and the assignment of income doctrine both point the same way. Therefore, an investor claiming capital gain must be ready to defend it, and a disclosure on Form 8275 is often prudent to protect against accuracy penalties.
The 40.8 Per Cent Tax That Nearly Passed
In May 2025 a Senate bill, the Tackling Predatory Litigation Funding Act, proposed a separate tax on funders' qualified litigation proceeds at a rate reaching 40.8 per cent. A version was added to the draft of the One Big Beautiful Bill Act, but the Senate parliamentarian ruled it outside the budget reconciliation rules, and it was removed before the Act was signed on 4 July 2025. The standalone bill has not been enacted. However, the policy debate continues into 2026, so any investor should assume the treatment of litigation funding could change during the life of a long case.
How HMRC Taxes the Same Return
Britain also lacks bespoke rules for the individual investor in litigation funding. Instead, the answer follows from general principles in the capital gains and income tax legislation.
A Chose in Action and the Capital Sum Rule
A contractual right to a share of future litigation proceeds is an asset for capital gains purposes. Under section 21 of the Taxation of Chargeable Gains Act 1992, assets include debts and incorporeal property, and a right to an unascertainable future sum is a recognised asset following the Marren v Ingles line of authority. Where the case settles and you receive a capital sum derived from that right, section 22 treats the receipt as a disposal. Consequently, the default British outcome for a private investor is a capital gain, taxed at 24 per cent for a higher rate taxpayer under the current capital gains tax rates.
When It Becomes Trading or Miscellaneous Income
That default treatment of litigation funding can shift. An investor who funds cases frequently, with an organised system and a commercial motive, risks being treated as carrying on a trade, with profits taxed as income at up to 45 per cent. Similarly, an agreement drafted as a true loan with a fixed return produces interest. Therefore, the more your litigation funding activity resembles a business, the more likely HMRC is to challenge capital treatment.
PACCAR and the Agreements That May Be Unenforceable
In July 2023 the Supreme Court held in PACCAR that funding agreements giving the funder a percentage of damages were damages-based agreements, unenforceable unless they complied with the relevant regulations. Funders responded by renegotiating returns as multiples of capital. The Government confirmed in December 2025 that it would legislate to reverse the ruling, following the Civil Justice Council's June 2025 recommendation. Nevertheless, the fix was omitted from the King's Speech on 13 May 2026, so the position remains unresolved.
This matters for the tax on litigation funding as well as for enforceability. A renegotiated agreement may be a variation or a disposal of the original right for capital gains purposes. Furthermore, a return reduced by a settlement over enforceability changes the amount on which both countries tax you. Accordingly, keep every version of every agreement, because your base cost and your gain depend on them.
Where the Two Systems Collide
The investment is identical in both countries, but the two tax results can diverge sharply. For an American investor in litigation funding, three collisions account for most of the extra cost.
The Character Mismatch and the Credit
Suppose Britain taxes your profit as a capital gain at 24 per cent and your American return treats it as ordinary income at 37 per cent plus the 3.8 per cent net investment income tax. The foreign tax credit can relieve only the 24 per cent paid in Britain. Consequently, roughly 17 percentage points of American tax survive, even before any sourcing problem. Where both countries agree on capital treatment, by contrast, British tax at 24 per cent exceeds the American 20 per cent rate and eliminates the regular American charge entirely.
Sourcing, the 10 Per Cent Test and the Treaty
The credit also requires the income to be foreign source. Under section 865, a gain on personal property is generally sourced by the seller's residence. A US citizen with a British tax home is treated as a non-resident for this purpose only if at least 10 per cent British tax is paid on the gain. British capital gains tax at 24 per cent comfortably clears that test, so a capital gain is foreign source and fully creditable.
An ordinary income characterisation is more dangerous. If the IRS treats a funder's share of damages from an American lawsuit as income arising in the United States, it is US source and the ordinary credit fails completely. The repair is Article 24(6) of the US-UK income tax treaty, which re-sources income to Britain to the extent necessary to avoid double taxation. Because a British resident who is not an American citizen would pay no American tax on such income under Articles 13 and 22, the whole obligation to relieve the double tax falls on the United States. However, the claim must be disclosed on Form 8833, and our treaty optimisation work builds it from the computation.
The Loss Asymmetry When a Case Fails
Losses from litigation funding reveal the harshest mismatch. If a funded case fails and your agreement is a capital asset, the termination produces a capital loss. In America, capital losses offset capital gains without limit but only $3,000 of ordinary income each year. Therefore, an investor whose winning case was taxed as ordinary income but whose losing case produced a capital loss suffers the worst combination: full tax on the wins and restricted relief for the losses. Consistency across the whole portfolio is essential, and it must be decided before the first case settles.
Funds, Syndicates and Reporting Obligations
The reporting burden of litigation funding depends on how you hold it, and several of the forms carry penalties far larger than the tax.
Litigation Finance Funds: Partnership or PFIC
A fund organised as a limited partnership is transparent for American purposes and issues a K-1, passing through the character of each case's return. A fund organised as a company in Guernsey, Jersey or the Cayman Islands, by contrast, will almost certainly be a passive foreign investment company, because its income is passive. The default PFIC rules convert every gain into ordinary income with an interest charge, destroying capital treatment. Accordingly, you would need a qualified electing fund election from the first year, which requires the fund to provide an annual information statement. Listed funders are companies too, so their annual reports should be checked for a PFIC statement before you buy.
Form 8938 and the FBAR Position
A direct funding agreement with a British claimant is a financial contract held for investment with a non-US counterparty. It is therefore a specified foreign financial asset on Form 8938 once your thresholds are met, which for an American abroad means $200,000 at year end or $300,000 at any time, doubled for joint filers. The IRS explains the rules in its comparison of Form 8938 and FBAR requirements. An agreement is not a financial account, so it generally stays off the FinCEN Form 114. However, the account through which you fund and receive payments is reportable, and our FBAR and FATCA reporting service covers both.
Questions to Ask Before You Commit Capital
A short set of questions before signing prevents most of the problems above. Ask the sponsor how each litigation funding agreement is drafted, whether it has taken a formal American tax position, and whether it will provide the information you need for a PFIC election or a K-1. Furthermore, ask how the return is calculated after PACCAR, whether any agreement has been renegotiated, and in which currency you will be paid, since a sterling receipt creates its own American currency gain or loss. Professional bodies such as the Chartered Institute of Taxation, the ICAEW and the AICPA all stress that cross-border investors need advice on their own position rather than the sponsor's. In our experience, an hour spent on the documents before investing routinely saves far more than it costs.
If the Filings Were Missed
Many investors discover these obligations only when a case finally pays out and a large receipt appears on a bank statement. Where earlier failures were not wilful, the IRS Streamlined Filing Compliance Procedures allow three years of amended or delinquent returns and six years of FBARs with penalties waived for qualifying non-residents. Our Streamlined filing service prepares the missing Forms 8938 and any PFIC filings within that submission.
A Worked Litigation Funding Case Study
Consider Rebecca, an American former portfolio manager living in London. In 2023 she invested £250,000 in each of two single-case litigation funding agreements, both drafted as prepaid forward contracts. Case A, an American patent claim by a British company, settled in 2026 and paid her three times her capital, £750,000. Case B, a commercial dispute, failed the same year, and her £250,000 was lost.
The Position Before We Reviewed It
Britain taxed the position as capital. Her £500,000 gain less the £250,000 loss, after the £3,000 annual exempt amount, left £247,000 taxed at 24 per cent, or £59,280, roughly $77,000. Her previous American preparer, however, reported Case A as $650,000 of ordinary other income from a US lawsuit and Case B as a capital loss limited to $3,000. The result was about $240,500 of regular American tax and $24,700 of net investment income tax, with no foreign tax credit, because the income had been reported as US source. Her combined tax exceeded the entire net economic profit.
What the Repairs Produced
We amended the return on her litigation funding positions on three points. Firstly, we treated both agreements consistently as capital assets under section 1234A, so the $650,000 gain and the $325,000 loss netted to a $325,000 long-term capital gain. Secondly, because British tax exceeded 10 per cent of the gain, section 865 sourced it abroad, and the $77,000 of British tax more than covered the $65,000 of regular American tax at 20 per cent. Thirdly, we disclosed the capital position on Form 8275 and filed the Form 8938 she had missed for both agreements.
What remained was the net investment income tax of about $12,350, which British tax cannot reduce. Consequently, her American bill fell from roughly $265,000 to $12,350. Importantly, none of that saving came from aggressive planning: it came from treating the whole portfolio consistently and applying the sourcing rules correctly.
How TaxYork Can Help
We prepare the American and British returns together, which is the only way to keep the characterisation consistent across both. A litigation funding profit reported one way in London and another way to the IRS is how the credit fails.
Our work on litigation funding starts with the agreements. We identify whether each is drafted as a loan, a participation or a prepaid forward contract, decide a single defensible position for the whole portfolio, and document it. Furthermore, we compute the sourcing, prepare any treaty disclosure, and handle the Form 8938, PFIC and Form 8275 filings.
For investors considering new positions, we model both returns before capital is committed, including the effect of a failed case. Above all, we quantify, so that the investment decision reflects the after-tax outcome in both countries. Our US tax return preparation for expats brings all of it into one filing.
Conclusion
Litigation funding can be a rewarding investment for an American in Britain, but it sits in a gap that neither tax system has filled. America offers no guidance on whether a funder's profit is capital or ordinary, and Congress nearly imposed a 40.8 per cent tax on it in 2025. Britain treats most private funders' returns as capital gains under general principles, while PACCAR leaves the agreements themselves in doubt.
The costliest outcome arises when the American return treats a win as ordinary income from a US lawsuit and a loss as a restricted capital loss. The cure is consistency: a single, documented capital position across the portfolio, foreign sourcing under section 865, and treaty re-sourcing where needed. Ultimately, the tax result depends as much on the paperwork as on the verdict, so the analysis belongs at the start of each investment rather than at the settlement.
Contact Us
If you hold, or are considering, litigation funding positions while living in Britain, we should review your agreements before the next case settles. Please contact us to discuss your portfolio, your reporting and any filings that were missed.
Email hello@taxyork.com or telephone 020 3488 8606. Alternatively, book a consultation and we will review your funding agreements alongside your UK Self Assessment before recommending anything.
Disclaimer
This article provides general information on litigation funding and does not constitute tax, legal or investment advice. Tax treatment depends on individual circumstances, the terms of each agreement and legislation in force at the time. You should obtain professional advice before acting on anything set out above. TaxYork accepts no liability for action taken in reliance on this article.