SRZ Client Alert:  “Proposed Bill Would Create New Tax Regime Introducing Uncertainty and Threatening Broad Credit Markets and Beyond”

Top corporate law firm Schulte Roth & Zabel LLP (“SRZ”) posted a recent client alert on Senator Tillis’s proposed litigation funding bill that was included in the Senate Finance Committee’s draft reconciliation text as “Chapter 50B—Litigation Financing”.  SRZ warns its clients that “[w]hile the Bill purports to address litigation funding, if enacted, the Bill would have an impact on broader financial markets, injecting uncertainty into numerous ordinary course financing transactions and potentially chilling corporate credit and other credit markets.” 

Under the current wording of the text, SRZ argues that even routine corporate credit transactions, including secured and unsecured lending, securitizations, purchases of subrogation claims from insurance companies, and debtor-in-possession lending, could be picked up by the expansive reach of the Bill.  SRZ further notes that the legislation would disregard the U.S. Tax Code’s longstanding principles regarding the taxation of pass-through entities and “would set a troubling precedent for addressing perceived grievances relating to different sectors of the economy”

If enacted, SRZ writes that the Bill would create a completely new income tax regime, likely resulting in significant uncertainty regarding its interaction with the traditional tax system and posing complex compliance challenges.  Below are SRZ’s further observations as to the impact of the Bill:

• Broad Scope and Definitions:  The Bill’s definitions are extremely broad. “Covered parties” include individuals, corporations, partnerships, and tax-exempt organizations, regardless of US or foreign status. The definition of “litigation financing agreement” is expansive, covering not only traditional litigation funding contracts but also any agreement that creates a direct or collateralized interest in litigation outcomes. The Treasury would have authority to treat similar arrangements as subject to the tax, potentially sweeping in ordinary asset financing and other unintended transactions.

• Impact on US Tax-Exempt Investors: The Bill would tax US tax-exempt investors (including pension plans and other tax-exempt entities) on litigation funding income, even if such income would not ordinarily be subject to US tax or would be considered capital gain under general principles. The legislation does not distinguish between US and foreign litigation, so both US and non-US investors could be subject to the tax even for non-US litigation.

• Double Taxation Risks: There is a significant risk of double taxation for investors, especially those investing through corporations or partnerships. For example, the highest marginal effective federal rate on qualified litigation proceeds could reach 54.89% for qualified dividends or 64.95% for non-qualified dividends or short-term partnership interests.

• Withholding and Compliance Challenges: The Bill introduces a new onerous withholding regime and complex compliance requirements for law firms and parties involved in litigation financing.

• Application and Effective Date: The Bill would apply to taxable years beginning after December 31, 2025, and would presumably apply even to existing litigation funding arrangements entered into prior to that date.