Litigation finance, or third-party litigation funding (TPLF), refers to an arrangement whereby a third party, which has no other connection to the litigation, finances some or all of a party’s (usually the claimant’s) legal costs in return for a share of any proceeds. The third-party litigation funder typically agrees to fund litigation in exchange for a fee, which is normally a percentage of the award made, or the settlement secured, in favour of the claim holder.
Litigation financing is generally provided on a non-recourse basis and the funded party is under no obligation to return the money to the litigation funder, whose return is therefore only secured by any proceeds from the funded case. The funder’s decision on whether to finance a claim therefore depends on factors such as:
The value of the claim;
The presumable costs and duration of the proceedings; and
The likelihood of success (also considering the defendant’s solvency and the prospects of recovering what is awarded by the judgment).
The rationale behind the practice is linked to the fact that some claimants could be at a disadvantage when pursuing a case, because of liquidity and/or risk constraints. For the funded party, TPLF represents an opportunity to improve access to justice in high-value disputes.
Although having features in common with certain agreements provided for by EU member states’ contractual law, TPLF agreements do not fall squarely within any one type of contract provided for in Italy’s legal system. From a civil law perspective, they must therefore be considered as ‘atypical’ or ‘unnamed’ contracts, the content of which may be freely chosen by the parties, based on the principle of contractual freedom.
The interpretative issue
Identifying the tax ramifications of TPLF agreements is a complex task, which requires a case-by-case analysis of the contractual arrangements and the factual circumstances.
As far as VAT is concerned, the European Parliament Research Service highlighted in its report Responsible private funding of litigation of March 2021 that “it is unclear whether EU rules on Value Added Tax (“VAT”) apply to the service (i.e. dispute financing) offered by the funder. On the contrary […] lawyers established in the EU are subject to VAT with respect to their fees, including contingency fees where applicable.
“In particular, it should be emphasised that the VAT regime depends on the structure of the funder (such as investment funds, corporations, financial institutions), the place of establishment of European and non-European funders and the legal construction of each litigation funding agreement [emphasis added].”
Three years later, the question concerning the VAT regime applicable to dispute financing services provided within the framework of TPLF agreements has been addressed to the Italian tax authorities for the first time.
Background to the advance ruling request
The applicant was a collective investment undertaking organised as a self-managed, multi-fund investment company with fixed share capital (SICAF) qualifying as a reserved alternative investment fund investing its assets in “credits and securities representing credits”, pursuant to Article 4(1)(e) of Decree No. 30 of the Ministry of Finance of March 5 2015, and “granting financing in any form whatsoever” through the purchase of receivables for consideration, pursuant to Article 2 of Decree No. 53 of the Ministry of Finance of April 2 2015.
In the furtherance of its business, the SICAF invests in disputed claims (of a monetary nature), by purchasing without recourse, pursuant to Article 1260 et seq. of the Italian Civil Code, all or part of a “disputed receivable” (i.e., a receivable requiring legal activity to be liquidated). In return, the SICAF:
Pays the holder of the disputed claim (which may be the subject of a legal action already commenced or yet to be commenced) a fee, generally composed of a fixed component, possibly a further component linked to the outcome of the litigation due by way of earn-out consideration, and the reimbursement of the litigation costs; and
Becomes entitled to receive all sums paid to the right holder (which normally remains the owner of the claim) arising out of, and/or in connection with, the purchased receivable (net of any earn-out to be paid to the right holder).
The tax advance ruling request of the SICAF was aimed at clarifying the VAT regime applicable to the supplies provided in the context of the TPLF agreements entered into by the SICAF, as founder, and the right or claim holder. In particular, the SICAF wanted the Italian tax authorities to confirm such transactions were to be qualified as VAT-exempt financial supplies made by the SICAF through the purchase of receivables.
The Italian tax authorities’ interpretation
The interpretative issue was addressed by the Italian tax authorities with Tax Ruling No. 83 of March 28 2024, which validated the taxpayer’s proposed solution.
The ruling highlights that on September 13 2022 the European Parliament released a resolution with which it invited the European Commission to draw up an EU directive to regulate the TPLF sector. Attached to the resolution is a proposal for an EU directive, in which the concepts of “litigation funder” and “third-party funding agreement” are defined, that highlights – as the resolution also does – that TPLF is a financial activity.
The Italian tax authorities affirm that the same financial cause can be found in the contractual schemes attached to the tax ruling request, which are used by the SICAF to provide the right holder financial resources to enable it to support the costs of the litigation, to manage the dispute, and to monetise its claim. These conclusions are corroborated by the regulatory profile of the SICAF, which is an entity supervised by the Bank of Italy.
The Italian tax authorities also argue that as long as the SICAF acquires receivables from its counterparty, the latter is deemed to have provided a service of a financial nature, consisting of the transformation of the assignor’s receivables into liquid assets before their natural maturity (or before the date of their presumed realisation) in return for a commission/discount, which constitutes the consideration for the service.
In this respect, the Italian tax authorities highlight that the clarifications in Tax Ruling No. 79/E of 2021 regarding the tax base of the assignment of non-performing loans are, mutatis mutandis, applicable. The tax base of a VAT-exempt financial transaction carried out by the SICAF through the purchase of the claim holder’s receivable should therefore be equal to the economic advantage gained by the SICAF, which is equal to the difference between the fair value of the receivables at the time of sale and the price paid by the assignee.
Since the proceeds deriving from the TPLF agreement and the price paid by the SICAF for the purchase of the receivable are, at least in part, staggered, the authors deem it correct that the taxable base of each transaction is determined by considering all the incoming and outgoing flows that can be estimated at the time of the purchase (and that are reasonably also considered by the investment committee and/or board of directors of the SICAF in the decision-making process). The flows should be discounted to the date of purchase of the credit on the basis of an appropriate rate (that takes into account the financial value of time and the risk associated with the funders’ activity).
