The threat of audit is an unhappy and seemingly unavoidable reality for companies of a certain size. In 2015, according to its own data, the IRS audited 64% of corporations with assets of over $5 billion and nearly all with assets over $20 billion. Two thirds of those audits led to increased tax assessments. Companies also regularly pursue refund claims involving substantial sums.
Needless to say, when corporations choose to dispute assessments or pursue claims, they do not undertake such litigation lightly. Pursuing a contentious tax claim requires a significant degree of confidence in one’s position and belief that the merits and ultimate value to the business outweigh the significant challenges ahead. Those challenges pertain not only to the stress of engaging in a dispute with an international, federal, state or local revenue authority but also the commitment of time and financial resources ahead.
That commitment of time and financial resources may be substantial. Even though nearly all corporate tax disputes settle, it’s common for large cases to take between three and seven years to resolve. During that time, companies must pay audit costs, legal fees and expenses, and the assessment continues to accrue interest. Some jurisdictions may also require partial to full payment of disputed taxes and the filing of a request for a refund before a matter can proceed. This translates to a three- to seven-year burden of cost and risk exposure, not only for the assessment itself, but also for the associated legal costs to reach a settlement. Refund claims are equivalent in duration and cost.
When clients pay for contentious tax disputes on their own balance sheets, it is harmful to corporate interests for a variety of reasons:
- Capital availability
On an obvious level, capital that would otherwise be available to the business is tied up pending a resolution. In jurisdictions that require a disputed tax assessment to be paid or held in escrow for the duration, sums will be even higher. - Accounting impact
Given the accounting treatment of legal expenses, the cost of pursuing the claim may result in a significantly negative impact on profitability. When companies spend millions of dollars on legal fees to pursue claims, they can’t capitalize those expenses (as they would for expenses associated with all other financial claims). Instead, they’re incurred through the organization’s P&L – thus reducing the company’s profit for the period. And refund claims do not provide any recognizable asset. - Share price impact
Publicly listed companies will see a negative valuation impact when pursuing litigation, regardless of their trading metrics. The ongoing expense of litigation reduces net profits and EBITDA, harming companies which trade on a P/E or an EV/EBITDA multiple. Companies which trade on book value are negatively impacted by the reduction in book assets, as cash is spent to pay for legal fees and expenses, without creating a corresponding asset. If the litigation is successful, it is classified as non-recurring and the company typically sees no valuation impact. Companies under customary borrowing arrangements see negative impact too, as the ongoing litigation expenses reduce ratios under their maintenance covenants.
Law firms that provide tax litigation services should certainly strive to understand how such challenges impact the companies they serve—but they may be limited in their ability to alleviate them for their clients. It is the rare firm that combines excellence in tax controversy and dispute resolution with the ability to provide litigation services on a fully contingent basis. And even those with such a winning combination will reach a limit of the cost and risk they can share.
Legal finance alleviates the burden on clients and firms
Clients engaged in tax disputes, and the law firms that serve them, may use outside capital to address many of the entrenched challenges of financing such litigation on balance sheets. Burford can help clients to offset cost and risk while they work to resolve contentious tax claims with government revenue authorities—or equip law firms to do so.
The concept is simple:
- As is standard in commercial litigation finance, Burford recognizes the asset value of a refund claim and advances capital on a non-recourse basis, with any return to Burford contingent upon its successful resolution.
- The capital can be used to manage the cost and risk of resolving the claim, for example to pay the legal fees and expenses incurred to resolve the tax dispute.
- For assessments, the company could pay Burford an amount that would discharge it from the ultimate liability in the event the challenge to the assessment is unsuccessful.
- By moving costs off the corporate balance sheet, the client can preserve cash for other business purposes and minimize the negative accounting and financial reporting impact that would otherwise be faced.
Law firms that work with companies engaged in contentious tax disputes may also use financing to enhance their litigation service offerings to clients:
- Financing enables all firms to expand their contingent fee practice in tax litigation while managing the significant exposure associated with long-running tax disputes.
- Financing allows primarily hourly firms to meet client demand for alternative fee arrangements and remain competitive in a fast-changing legal market.
Burford can also provide financing in tax-related whistleblower matters.
Ultimately, the use of legal finance in tax disputes is attractive to clients and law firms for the same reasons that legal finance is embraced in other areas of commercial litigation and arbitration. Clients recognize that outside financing enables them to pursue meritorious tax claims without adding to corporate cost and risk, and without harming profitability and share price. Law firms welcome a tool that helps them expand their tax litigation services to clients.
