U.S. Senate Draft of the Reconciliation Bill Introduces New Punitive Excise Tax Regime for Litigation Financing

On June 16, 2025, the U.S. Senate Finance Committee released its draft text for HR 1, commonly known as the One Big Beautiful Bill Act. This version introduces a new punitive excise tax regime for litigation financing, which is absent from the version of HR 1 passed by the House of Representatives on May 20, 2025.¹

Current Law

Under current law, litigation finance arrangements often take numerous legal forms such as loans, partnership interests, option contracts, or prepaid forward contracts, depending on the facts and circumstances. That is, under current law, the general principles applicable to different financial instruments that have been developed over decades are also applied to litigation finance. As a result, the portfolio interest exemption, Section 892², a tax treaty exemption or the capital gain exemption to U.S. withholding taxes, may apply to a particular litigation finance arrangement involving foreign investors, and a litigation finance arrangement may generate long-term capital gains in typical carried interest structures of U.S. participants related to litigation finance, including by way of Section 1234A.

Summary of New Proposed Regime

• The new tax on “qualified litigation proceeds” received is designed as a special excise tax (new Section 5000E-1 in Subtitle D) and is therefore outside the scope of the regular income tax.
  • No income tax treaty protection applies for “qualified litigation proceeds” because tax treaties would not apply to this type of new excise tax.
  • “Qualified litigation proceeds” are expressly excluded from the “gross income” definition for income tax purposes, making the capital gain preferences and exemptions such as the portfolio interest exemption or Section 892 inapplicable.
  • The carried interest rules of Section 1061 are inapplicable to “qualified litigation proceeds.”
• The tax is imposed on a “covered party” at a rate of 40.8% (the highest individual tax rate plus 3.8%) on the “qualified litigation proceeds” that are “received” by such “covered party.”
  • “Qualified litigation proceeds” means as “an amount equal to the realized gains, net income, or other profit received by a covered party during a tax year which is derived from, or pursuant to, any litigation financing agreement.”
  • “Litigation financing agreement” means, with respect to any “civil action,” a written agreement (i) whereby a third party agrees to “provide funds” to one of the named parties or any law firm affiliated with such “civil action” and (ii) that creates a “direct or collateralized interest in the proceeds of such action” (by settlement, verdict, judgment, or otherwise) that (x) is based, in whole or in part, on a funding-based obligation to such “civil action” or the law firm or counsel and (y) is executed with either any named party in such “civil action” or any counsel or law firm involved in such “civil action.” The term “litigation financing agreement” also includes “any contract (including any option, forward contract, futures contract, short position, swap, or similar contract) or other arrangement which, as determined by the [Treasury Secretary], is substantially similar to an agreement” covered by the general definition of “litigation financing agreement.”
  • “Civil action” means “any civil action, administrative proceeding, claim, or cause of action.”
  • “Covered party” means, with respect to any civil action, any third party to such civil action who receives funds pursuant to a litigation financing agreement and is not an attorney representing a party to such civil action.
• While the excise tax must ultimately be paid by the covered party, the proposed law also imposes new withholding requirements on “applicable persons” (i.e., any named party to a civil action and any involved law firm in such civil action if they have entered into a litigation financing agreement) with respect to payments made to a covered party.
  • The withholding tax rate is half the excise tax rate (i.e., currently 20.4%).
  • This new withholding regime would create a significant compliance burden for law firms.
• If a covered party is a partnership, S corporation, or other pass-through entity, then the new excise tax is imposed on the entity level.
• This new excise tax applies to tax years beginning after December 31, 2025.

Initial Observations

• No Grandfathering. The Senate draft bill does not include any grandfathering provisions for existing litigation financing agreements. Thus, each existing litigation financing agreement would be within the scope of the new excise tax if proceeds in respect of any such existing litigation finance agreement are collected during tax years beginning after December 31, 2025. In addition, the withholding tax obligations would apply to such existing agreements.
• Worldwide Scope. The definition of “civil action” is remarkable because it does not include any reference to either (i) the use of U.S. courts or (ii) a U.S. plaintiff or (iii) a U.S. defendant or (iv) a cause of action arising under U.S. law. As a result, for example, a Japanese corporation that brings a damage claim against an Australian company under a merger-and-acquisition agreement governed by Italian law in a UK court would be subject to the excise tax even if the Japanese company’s litigation financing agreement counterparty is a non-U.S. litigation funder.
• Entity Level Tax at 40.8%. Because the new excise tax applies at the entity level, it essentially creates a regime in which each entity is treated as a corporation and each such entity is subject to a 40.8% tax. Note that because this is a separate excise tax, the regular corporate tax rate of 21% is irrelevant in the case of entities that are taxed as corporations for U.S. federal income tax purposes. Accordingly, the new excise tax ignores tiered entity structures and does not look through the tax status of the ultimate owners.
  • As a result, state pension plans and other “super tax-exempt investors” would be subject to this excise tax.
  • This regime is significantly more penalizing than the audit tax regime for partnerships.
  • In the case of entities taxable as U.S. corporations (e.g., so-called “blocker corporations” in the investment partnership context), a highly problematic question of double taxation arises because it is unclear how a U.S. corporation’s distribution of its after-tax qualified litigation proceeds to its shareholders would be treated. If the qualified litigation proceeds are reflected in the corporation’s “earnings and profits” for tax purposes, then such a distribution would be treated as a taxable dividend, potentially subject to 30% dividend withholding tax in the hands of foreign shareholders. That could result in an aggregate U.S. tax burden of 58.56% for foreign investors without any treaty or Section 892 protection on such a distribution.
• Affects Both U.S. and Non-U.S. Persons. Although, according to press coverage, the new excise tax targets non-U.S. investors in litigation financing over U.S.-based claims, it reaches both U.S. and non-U.S. investors because the definition of “covered party” does not distinguish between U.S. and non-U.S. persons.
• No Offsets With Losses From Other Investments. Because the excise tax is a tax separate from the regular income tax, losses arising under the regular income tax regime (e.g., from normal stock and bond investments) could not be used to reduce the amount of qualified litigation proceeds subject to the excise tax. It appears that qualified litigation proceeds could only be offset by lost investments in litigation financing agreements that would have been subject to the new excise tax had they been successful.
• Tax Basis Recovery Rules Unclear. The tax is imposed on qualified litigation proceeds “received,” and “qualified litigation proceeds” are defined as “profits.” It is, therefore, unclear whether this creates a pure cash method accounting concept for purposes of the excise tax superseding the tax accounting rules that would otherwise apply under the regular income tax. This raises the question about how tax basis should be recovered (i.e., recover tax basis first?). For example, a litigation financing agreement has been structured as a contingent payment debt instrument (CPDI): Which accounting method must be applied by the covered party? Cash method only? The general rules applicable to CPDIs? A combination thereof?
• Litigation Financing Agreement and Normal Debt Financings. This definition is extraordinarily broad because “litigation finance arrangement” means essentially any civil action in respect of which there is a “funding” arrangement and the funding arrangement payoff is contingent on the outcome of the financed litigation, irrespective of whether the arrangement is entered into with a law firm or a named party of the litigation.
  • The only exception from this broad definition is a straight loan with an interest rate not to exceed the greater of (i) 7% or (ii) 2 x 30-year Treasury yield (currently approx. 10%). This straight debt exception is of limited use because, it seems, if the interest rate is just one basis point too high, the entire loan (i.e., the entire proceeds in excess of tax basis) would become subject to the new excise tax.
    • Accordingly, an existing normal credit line from a bank to a law firm with a fixed but too-high interest rate could be subject to the new excise tax if the credit line is secured, at least in part, with proceeds from litigation handled by the law firm.
    • Debtor-in-possession (DIP) loans in corporate restructurings could also be subject to the excise tax if the DIP loan is in part secured by litigation proceeds and the interest rate is too high.
    • It is unclear whether it is, in fact, intended to cover such routine commercial arrangements that are generally not conceptualized as litigation financing (in particular, if such loans are structured as customary variable rate loans as opposed to fixed-rate loans).
  • Note that the general definition of “litigation financing arrangement” does not specify how “to provide funds” is legally structured (e.g., purchase, contribution, derivative, prepaid forward, loan). And the term “direct or collateralized interest” is very broad and, again, does not exactly say which legal construct counts toward this concept. Does, for example, one need a pledge as a legal matter to have a “collateralized interest,” or does a special purpose vehicle structure without a pledge suffice? Thus, the Treasury Secretary has a lot of discretion to clarify the scope under the “substantially similar agreement” rule.
• Tiered Structures. Although not entirely clear, it appears that in a tiered ownership structure the excise tax would not be triggered multiple times with respect to the same litigation financing agreement because the upper-tier instruments that could be litigation financing agreement” are likely outside the scope of that definition because neither the named party nor the involved law firms are counterparties to those upper-tier legal instruments (e.g., stocks, partnership interests, loans).
• Likelihood of Enactment. It is unclear whether this new excise tax, which has been scored as a revenue raiser (although a small one), will survive the conference of the House and the Senate and will be retained in the final version of HR 1. We will continue to monitor developments in this regard. 

¹ Sen. Thom Tillis, Republican of North Carolina, had introduced the Tackling Predatory Litigation Funding Act on May 20, 2025 (the Tillis Proposal). Although a companion bill was introduced to the House of Representatives on the same day, the following day the House passed HR 1 without including the Tillis Proposal. The released text of the Senate draft of HR 1 includes, without changes, the Tillis Proposal.
² All references to a “Section” are references to sections of the Internal Revenue Code of 1986, as amended.