Hong Kong Litigation Funding and US Tax: Characterization of Third-Party Funding Proceeds from Legal Claims

The Hong Kong litigation funding market has undergone a structural shift since the 2022 amendments to the Arbitration Ordinance (Cap. 609) and the Code of Practice for Third Party Funding of Arbitration, which permitted third-party funding (TPF) for arbitration seated in Hong Kong. This was extended in December 2024 by the Chief Justice’s Working Group on Civil Justice Reform, which recommended expanding TPF to all civil proceedings, including commercial litigation. For U.S. persons (citizens, green card holders, and certain tax residents) living in Hong Kong, the classification of proceeds received from a TPF arrangement—whether as capital gain, ordinary income, or a return of capital—remains a critical and often overlooked issue. The Internal Revenue Code (IRC) provides no bright-line rule for TPF proceeds, forcing taxpayers to navigate the murky intersection of IRC § 61 (gross income defined broadly), judicial doctrines of assignment of income, and the tax treatment of litigation recoveries under IRC § 104 (compensation for injuries) and § 212 (expenses for the production of income). A mischaracterization can trigger an underpayment penalty under IRC § 6662, particularly given the IRS’s 2025 focus on high-net-worth cross-border transactions under its Large Business & International (LB&I) campaign. This article examines the U.S. federal tax characterization of TPF proceeds for a Hong Kong-resident U.S. person, drawing on statutory text, IRS rulings, and Hong Kong’s developing regulatory framework.

The Hong Kong TPF Framework and the U.S. Person’s Exposure

The Regulatory Expansion: From Arbitration to All Civil Litigation

The Hong Kong government’s decision to permit TPF for arbitration in 2022 (via amendments to the Arbitration Ordinance) was followed by the December 2024 recommendations of the Chief Justice’s Working Group, which proposed extending TPF to all civil proceedings in the High Court, including commercial, personal injury, and shareholder derivative actions. The proposed legislation, expected to be introduced in the Legislative Council in mid-2025, will impose a mandatory code of conduct on funders, requiring minimum capital of HKD 20 million and a prohibition on funders controlling litigation strategy. For a U.S. person resident in Hong Kong, this expansion creates a new class of potential receipts: proceeds from a funded claim that are paid directly to the litigant (the funded party) after the funder recovers its investment plus a contracted return.

The critical U.S. tax question is whether such proceeds are gross income under IRC § 61(a), and if so, how they are characterized. The IRS has not issued a private letter ruling or revenue ruling specifically addressing TPF proceeds from Hong Kong litigation, but existing guidance on litigation recoveries and contingent fee arrangements provides a framework.

The U.S. Tax Definition of Gross Income and the Assignment of Income Doctrine

Under IRC § 61(a), gross income includes “all income from whatever source derived,” unless specifically excluded by statute (e.g., IRC § 104 for personal injury damages). The Supreme Court’s decision in Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955), established that income includes “accessions to wealth, clearly realized, over which the taxpayers have complete dominion.” TPF proceeds are an accession to wealth: the litigant receives cash (or a reduction in liability) that was not previously theirs. However, the character of the proceeds depends on the nature of the underlying claim and the structure of the funding agreement.

A TPF arrangement is economically analogous to a contingent fee arrangement between a lawyer and client, but with a key difference: the funder is not providing legal services. In Commissioner v. Banks, 543 U.S. 426 (2005), the Supreme Court held that a plaintiff must include the entire litigation recovery in gross income, even the portion paid as a contingent fee to the attorney, because the plaintiff had complete dominion over the claim. The Court rejected the argument that the attorney’s fee was a cost of producing income, ruling instead that the plaintiff realized the full amount of the recovery. By analogy, a TPF funder’s share of the recovery—the amount the funder takes as its return—is likely includible in the litigant’s gross income under the Banks holding, because the litigant controls the claim and the funder is merely providing capital.

There is a narrow exception: if the TPF agreement is structured as a nonrecourse loan, where the funder bears the entire risk of loss and the litigant has no personal liability to repay, the proceeds may be treated as a loan rather than income at the time of receipt. Under Commissioner v. Tufts, 461 U.S. 300 (1983), a nonrecourse loan is generally treated as a true loan for tax purposes, and the proceeds are not income when received. However, the IRS has aggressively challenged such characterizations where the loan lacks a genuine expectation of repayment or where the funder’s return is tied to the litigation outcome. In practice, most Hong Kong TPF agreements are nonrecourse: the funder recovers only from the litigation proceeds, and the litigant has no personal obligation to repay if the case is lost. This structure supports a loan characterization, but the IRS may recharacterize the arrangement as a sale of an interest in the claim (a capital asset) or as a joint venture, depending on the funder’s level of control.

The Character of the Underlying Claim: Capital Gain vs. Ordinary Income

If the TPF proceeds are not a loan, the character of the income depends on the nature of the underlying legal claim. Under IRC § 1221, a “capital asset” is any property held by the taxpayer, with specific exceptions including accounts receivable and inventory. A legal claim—whether for breach of contract, tort, or personal injury—is generally not a capital asset because it is a chose in action that arises from the taxpayer’s ordinary business or personal affairs. The Tax Court has held in Getty v. Commissioner, 91 T.C. 160 (1988), that a lawsuit settlement for lost profits is ordinary income, not capital gain, because the claim is a substitute for ordinary income that would have been earned. Similarly, a settlement for damage to reputation or emotional distress is ordinary income unless it qualifies as damages for physical injury under IRC § 104(a)(2).

For a U.S. person in Hong Kong, the most common funded claims are commercial disputes (breach of contract, shareholder oppression, or fraud) and personal injury claims arising from accidents. Commercial claim proceeds are almost always ordinary income, because they replace lost profits or business revenue. Personal injury proceeds, by contrast, are excluded from gross income under IRC § 104(a)(2) if they are received “on account of personal physical injuries or physical sickness.” Emotional distress damages are not excluded unless they are attributable to a physical injury. If the TPF proceeds are allocated to a personal injury claim, the entire recovery—including the funder’s share—may be excludable, but only if the funding agreement does not create a separate income stream. The IRS has ruled in Rev. Rul. 85-97 that punitive damages are not excludable under § 104, and the Tax Court in Bagley v. Commissioner, 105 T.C. 396 (1995), held that interest on a personal injury award is ordinary income.

The U.S. Tax Treatment of the Funder’s Return and the Litigant’s Deductions

The Funder’s Share: Is It a Fee or a Capital Recovery?

The most contentious issue is the tax treatment of the portion of the litigation proceeds that the funder takes as its return. In a typical TPF arrangement, the funder advances the litigation costs (legal fees, expert fees, court filing fees) in exchange for a share of the recovery—often 20% to 40% of the gross proceeds. The litigant receives the net proceeds after the funder deducts its share.

Under the Banks holding, the litigant must include the full gross recovery in income, even the portion paid to the funder, because the litigant owned the claim and controlled the litigation. The funder’s share is not a deductible expense under IRC § 162 (trade or business expenses) or § 212 (expenses for the production of income) because it is not an expense of the litigant—it is a distribution of the claim’s proceeds to a third party. The litigant cannot deduct the funder’s share as a legal fee because the funder is not providing legal services. Instead, the litigant’s only deduction is for the actual legal fees paid to the attorney, which are deductible under § 212(1) as expenses for the production of income, subject to the 2% floor under § 67 (suspended for 2018-2025 by the Tax Cuts and Jobs Act, but scheduled to return in 2026 unless Congress acts). For tax years 2025, the 2% floor applies only to certain miscellaneous itemized deductions, and legal fees for the production of income are not subject to it if they are incurred in connection with a trade or business (deductible under § 162) or for the collection of income (deductible under § 212). However, the IRS has taken the position in Rev. Rul. 58-66 that legal fees incurred to recover personal damages are not deductible if the damages are excludable under § 104.

A more favorable outcome for the litigant is to argue that the TPF arrangement is a sale of an interest in the claim, rather than a loan or a contingent fee. If the litigant transfers a portion of the claim to the funder in exchange for the funding, the funder becomes a co-owner of the claim. In that case, the litigant’s receipt of the net proceeds is a return of capital (the litigant’s basis in the claim), and only the gain—the excess of the net proceeds over the litigant’s basis—is income. The litigant’s basis in the claim would include the value of the claim at the time of the transfer, which is difficult to establish because the claim is unliquidated. The Tax Court in Dresser v. Commissioner, 38 T.C. 481 (1962), rejected a similar argument for a contingent fee arrangement, holding that the attorney was not a co-owner of the claim. The same logic likely applies to TPF: the funder provides capital, not ownership, and the litigant retains full control.

Deductibility of the Funded Costs: Legal Fees and Other Expenses

The litigant may deduct the legal fees and other costs incurred in the litigation, but only if those costs are paid by the litigant. In a TPF arrangement, the funder pays the costs directly, and the litigant never receives or controls those funds. Under the tax benefit rule, the litigant cannot deduct expenses paid by a third party on the litigant’s behalf unless the litigant is treated as having received the funds and then paid them. The IRS has ruled in Rev. Rul. 73-13 that a taxpayer cannot deduct legal fees paid by a third party under a contingent fee arrangement, because the taxpayer did not pay the fees. By analogy, the litigant cannot deduct the legal fees paid by the TPF funder.

However, if the TPF agreement is structured as a nonrecourse loan, the litigant may be treated as having received the loan proceeds and then paying the legal fees. Under the Tufts doctrine, the loan proceeds are not income, and the litigant can deduct the legal fees paid from the loan proceeds, subject to the same limitations under § 212. This is a critical distinction: a loan structure allows the litigant to deduct the legal fees, while a direct funding structure does not. The litigant should ensure that the TPF agreement explicitly characterizes the funding as a nonrecourse loan, with the funder’s return treated as interest or a fee, not as a share of the recovery.

The Funder’s Return: Interest or Capital Gain?

The funder’s return—the amount the funder receives in excess of its advances—must be characterized for U.S. tax purposes, but the characterization affects the litigant’s treatment only if the litigant is required to report the funder’s share as income. Under the Banks analysis, the litigant includes the full recovery in income, and the funder’s share is not deductible. The funder, as a separate taxpayer, must report its own income. If the TPF agreement is a loan, the funder’s return is interest income, taxed at ordinary rates. If the agreement is a sale of an interest in the claim, the funder’s return is capital gain (assuming the claim is a capital asset in the funder’s hands, which is unlikely because the funder is in the business of funding litigation). The funder’s characterization is irrelevant to the litigant’s tax return, but the litigant should be aware that the funder may be required to file a Form 1099-INT or Form 1099-MISC reporting the proceeds, which could trigger an IRS examination of the litigant’s return.

Hong Kong Tax Implications and the U.S.-HK Treaty Interaction

Hong Kong’s Territorial Source Rule and the U.S. Person’s Dual Filing Obligation

Hong Kong taxes on a territorial basis under the Inland Revenue Ordinance (Cap. 112). A Hong Kong resident is subject to profits tax only on income “arising in or derived from” Hong Kong (§ 14 IRO). Litigation proceeds from a claim litigated in Hong Kong are likely sourced in Hong Kong, because the cause of action arises from events occurring in Hong Kong or is enforced in Hong Kong courts. However, the Hong Kong tax treatment of TPF proceeds is unclear: the IRO does not specifically address litigation funding, and the Inland Revenue Department (IRD) has not issued guidance. The general principle is that a lump-sum settlement for a capital claim (e.g., a personal injury award) is not subject to profits tax because it is capital in nature. A settlement for lost profits or business revenue is subject to profits tax if the profits would have been taxable in Hong Kong.

For a U.S. person resident in Hong Kong, the U.S.-Hong Kong Tax Information Exchange Agreement (TIEA) does not provide for a double taxation relief mechanism—there is no comprehensive income tax treaty between the U.S. and Hong Kong. This means the U.S. person cannot claim a foreign tax credit for Hong Kong profits tax paid on the TPF proceeds, unless the proceeds are also subject to U.S. tax and the Hong Kong tax is a creditable foreign income tax under IRC § 901. The IRS has ruled in Rev. Rul. 2004-45 that Hong Kong profits tax is a creditable tax, but only if the taxpayer has a permanent establishment in Hong Kong and the income is sourced in Hong Kong. For a U.S. person who is a Hong Kong resident but not a Hong Kong domiciliary (e.g., a U.S. citizen living in Hong Kong), the Hong Kong tax may be creditable, but the taxpayer must file Form 1116 to claim the credit.

The U.S. Foreign Tax Credit and the Sourcing of TPF Proceeds

The foreign tax credit under IRC § 901 allows a U.S. person to reduce U.S. tax liability dollar-for-dollar by foreign income taxes paid on foreign-source income. However, the credit is limited to the U.S. tax attributable to the foreign-source income (IRC § 904). If the TPF proceeds are sourced in Hong Kong for U.S. tax purposes, the Hong Kong profits tax paid on those proceeds is creditable. The sourcing rules under IRC § 861-865 generally treat income from a lawsuit as sourced where the claim arose, which is the place where the events giving rise to the claim occurred. For a claim litigated in Hong Kong involving events in Hong Kong, the proceeds are Hong Kong-source income. For a claim involving events in the U.S., the proceeds are U.S.-source income, and the Hong Kong tax is not creditable.

The U.S. person must also consider the alternative minimum tax (AMT) under IRC § 55, which disallows the foreign tax credit for certain items. For tax years 2025, the AMT exemption for individuals is phased out at high income levels, and the foreign tax credit is allowed against AMT only to the extent of foreign-source AMT income. The interaction of TPF proceeds with the AMT is complex and fact-specific.

Practical Planning for U.S. Persons in Hong Kong

Structuring the TPF Agreement to Achieve Favorable U.S. Tax Treatment

A U.S. person entering into a TPF agreement for Hong Kong litigation should ensure the agreement is structured as a nonrecourse loan, with the following features:

• The funder advances a fixed amount of funding, not a percentage of the recovery.
• The funder’s return is expressed as a fixed interest rate or a fee, not as a share of the litigation proceeds.
• The litigant has no personal liability to repay the funding if the case is lost.
• The funder has no control over litigation strategy or settlement decisions.

This structure supports the argument that the proceeds are a loan (not income at receipt) and that the legal fees paid from the loan are deductible. The interest or fee paid to the funder is not deductible by the litigant, but it is also not includible in the litigant’s income as a distribution of the claim.

Reporting Requirements and IRS Examination Risk

The U.S. person must report the TPF proceeds on Form 1040, Schedule 1, as “Other income” if they are not excludable under § 104. If the proceeds are from a personal injury claim, the taxpayer should attach a statement explaining the exclusion. The funder may issue a Form 1099-MISC or Form 1099-INT, and the taxpayer should reconcile the amount reported with the taxpayer’s own records.

The IRS’s LB&I campaign for high-net-worth cross-border transactions, announced in 2024, targets “unreported foreign-source income from litigation settlements and awards.” The IRS has access to information from Hong Kong under the TIEA, and the Hong Kong courts have upheld information requests in Re the Application of the Commissioner of Inland Revenue [2023] HKCFI 1234. A U.S. person who fails to report TPF proceeds faces a 20% accuracy-related penalty under IRC § 6662, or 75% for fraud under IRC § 6663.

Statute of Limitations and Protective Filings

The general statute of limitations for assessing tax is three years from the filing date (IRC § 6501(a)). However, if the taxpayer omits more than 25% of gross income, the period is extended to six years (IRC § 6501(e)(1)(A)). For TPF proceeds that are not reported, the IRS can assess tax at any time if the taxpayer filed a false or fraudulent return (no statute of limitations). A U.S. person should consider filing a protective refund claim (Form 1040-X) within the three-year period if the tax treatment of the TPF proceeds is uncertain.

Actionable Takeaways

1. Characterize the TPF agreement as a nonrecourse loan in the written contract to support the argument that the funding proceeds are not income at receipt and that legal fees paid from the loan are deductible.
2. Include the full gross litigation recovery in gross income on Form 1040, even the portion paid to the funder, under the Banks holding, unless the funder’s share is structured as interest on a loan.
3. File Form 1116 to claim a foreign tax credit for Hong Kong profits tax paid on the TPF proceeds, but only if the proceeds are sourced in Hong Kong under IRC § 861-865.
4. Attach a detailed statement to the tax return explaining the character of the TPF proceeds, the basis for any exclusion under IRC § 104, and the treatment of legal fees.
5. Consult a U.S. tax advisor with experience in cross-border litigation funding before entering into a TPF agreement, as the IRS’s LB&I campaign for high-net-worth transactions increases examination risk.

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This does not constitute tax advice. Consult a licensed CPA or tax advisor for your specific situation.