Congress should close the capital-gains loophole that rewards foreign money for funding suits against American companies.
Congress should close the capital-gains loophole that rewards foreign money for funding suits against American companies.
L ast month, at a House Financial Services Committee hearing on international finance, Treasury Secretary Scott Bessent made a striking criticism. Asked about third-party litigation funding, in which outside investors, many of them foreign, bankroll lawsuits against American companies for a share of the proceeds, Bessent called it a “malignancy within our legal and financial system.”
That language deserves serious attention. Nobody asked Bessent to call it a malignancy. He chose the word. A Treasury secretary with a crowded agenda doesn’t reach for it unless the problem runs deep.
Representative Mike Flood (R., Neb.) laid out why, saying that he was concerned about sovereign wealth funds “gaming our justice system, getting these nuclear verdicts, and then paying themselves back big time.” These arrangements let investors convert ordinary income from litigation recoveries into capital gains through financial engineering. He reminded Bessent of his own recent warning that “Tax rules should reward investment, not abusive financial engineering,” and said litigation finance fits that description “to a T.”
“Will you work with us,” Flood asked Bessent, “to ensure that TPLF proceeds are subject to the appropriate U.S. tax treatment?”
Bessent’s response was unambiguous: “I look forward to working with you and your staff on that.”
The problem is straightforward. When a plaintiff wins taxable damages, such as lost profits, the money is generally taxed as ordinary income. When a third-party funder that financed that same lawsuit collects its contractual share, it often treats those earnings as a capital gain and pays a lower rate on the same proceeds. It is the same pot of money, taxed differently depending on who receives it. For a foreign funder, it may not be taxed at all. Foreign investors generally owe no U.S. tax on capital gains from domestic sources.
What Flood described, and Bessent condemned, is a loophole that effectively subsidizes foreign speculation in costly, and often very profitable, lawsuits against American companies. The economic substance does not change because an investor purchased the right to receive a portion of the income. The income was ordinary before the funder arrived. It remains ordinary after the funder departs with its share. Yet current tax treatment allows transaction structure to override economic reality.
This principle is deeply rooted in American tax law. In Commissioner v. P. G. Lake (1958), the Supreme Court looked past the form of the deal and held that a lump sum received in place of future ordinary income is taxed as ordinary income, not capital gain. The Court stressed that capital-gains treatment is an exception, narrowly construed to protect the revenue against “artful devices.”
Contingency-fee lawyers show why. Long before litigation finance became a multibillion-dollar market, they provided plaintiffs a form of litigation funding. A lawyer supplies legal services without immediate payment and risks receiving nothing if the case fails. If the client prevails, the lawyer takes an agreed percentage of the proceeds. That compensation is ordinary income. We don’t treat a lawyer’s share as capital gains merely because it is contingent on the outcome of the case.
Commercial litigation finance changes what the funder contributes, not the basic arrangement. Instead of legal labor, the funder contributes capital. Like the lawyer, it assumes litigation risk in exchange for a contractual share of the proceeds. Should passive capital receive preferential tax treatment for essentially the same risk-sharing arrangement?
It should not. There is no tax policy justification for this practice.
We were among the 80 economists who signed an open letter to Congress raising the alarm earlier this year. It notes that advantageous capital-gains tax rates exist to encourage productive, risk-bearing investment, and passive litigation finance is hard to reconcile with that rationale. It also cites Swiss Re Institute data showing that the United States generates roughly a quarter of global GDP but accounts for more than half of worldwide litigation-funding activity. Industry estimates put the global market at about $19 billion in 2024, with projections above $50 billion by 2032.
There is a legislative fix. Whether P. G. Lake already covers litigation funders is an open question, and Congress should not wait for the courts to answer it. We urged Congress to tax funders’ profits “in the same manner as damages received by prevailing plaintiffs.”
The Tackling Predatory Litigation Funding Act, sponsored by Representative Kevin Hern (R., Okla.), moves in that direction. It would tax those proceeds at ordinary income tax rates and require withholding when they are paid, so the tax is collected at the source instead of chased overseas afterward. It does not ban litigation finance or dictate which cases get funded.
Congress must now act before more settlement proceeds can flow offshore untaxed, and before foreign money learns it can game both our justice system and our tax code with impunity.
The tax principle at stake is not new. Ordinary income must be taxed as ordinary income. What is new is that the Treasury secretary says he is willing to help.
David Malpass is a former president of the World Bank. Previously, he served as senior tax analyst for the Senate Budget Committee. James Carter is a former deputy assistant secretary of the treasury. Previously, he served as a senior tax adviser to the Senate Budget Committee.