The Cash-Flow Problem Matter Funding Solves
Litigation locks up a law firm's cash for years. The disbursements on a case, court and tribunal fees, expert and medical reports, counsel's fees and searches, are paid out early, often long before the matter resolves. And on conditional-fee and damages-based work the firm's own fees may not crystallise until the win, which can be two or three years away. The result is a firm financing both its outlays and its own time across a long contingent period.
Matter-level funding products exist to bridge that gap. There are three broad types: disbursement funding (an outlay loan), third-party litigation funding (an external funder finances the case for a share of the recovery), and after-the-event insurance (cover against the downside if the case is lost). This is distinct from firm-level borrowing, the overdrafts, term loans and invoice discounting that finance the practice as a whole, which we cover in our guide to solicitor practice finance options. This page is about case-level money.
The questions that follow are practical and recurring: is the funding fee or interest deductible, what happens to the VAT on funded disbursements, where does funded money sit under the SRA Accounts Rules, and how does after-the-event insurance fit in after LASPO. The deferred profit profile of conditional-fee and damages-based work, which is what creates the cash gap in the first place, is covered in our companion guides to the CFA success-fee model and the DBA percentage-of-damages model. This guide maps the funding products to their cash-flow role, then works through the tax, VAT and SRA treatment.
Disbursement Funding (the Outlay Loan)
Disbursement funding is the simplest of the three products. A lender advances the cost of the case outlays, court fees, experts, medical reports, counsel, searches, as they fall due, and the advance is repaid on settlement or recovery, usually with interest or a fee. Its cash-flow role is to keep the firm's own working capital free, which matters most on volume personal-injury and conditional-fee caseloads where dozens or hundreds of matters each carry several thousand pounds of outlays.
The single most important question for the books is who borrows. The loan may be taken by the firm (the firm draws down the funding, pays the disbursements, and repays the lender) or by the client (the loan is in the client's name and the firm administers the funded money on the client's behalf). That distinction drives both the deductibility of the funding cost and how the money is recorded, and it runs through the rest of this guide. Many disbursement-funding products are structured as loans to the client precisely so the cost sits with the client rather than the firm.
Third-Party Litigation Funding (TPLF)
Third-party litigation funding is a larger-scale product. An external funder finances the costs of a piece of litigation in return for a share of the recovery, typically expressed as a multiple of the sum advanced or a percentage of the damages. In the usual case the funding is non-recourse: if the claim fails, the funder loses its investment and the funded party owes nothing further. That risk-sharing is what makes TPLF attractive on large, lengthy commercial cases that would otherwise be too expensive or too risky to run.
The regulatory and case-law detail around litigation funding, including the historic position on a funder's exposure to adverse costs, is a specialist field and is outside the scope of this accounting guide. For the firm's books, the key points are that the funder's return is a cost borne by the funded party (the client, or occasionally the firm) and not a simple interest deduction in the firm's accounts, and that the funded party must understand and disclose the cost. The firm's own fees on a TPLF-backed case are recognised under the normal rules; the funding sits alongside, not inside, the firm's revenue.
A point of confusion worth heading off is that third-party funding is not the firm's borrowing even though it pays for the firm's work. The funder typically contracts with the client (or, in some structures, advances money against the claim itself), and the firm is paid out of the proceeds in the ordinary way. So the funder's multiple or percentage return does not appear as a finance cost in the firm's profit and loss account, and the firm cannot deduct it. What the firm does have to manage is the documentation: the priorities agreement or waterfall that determines who is paid in what order out of any recovery, and the client-care explanation of how the funder's return reduces the client's net sum. Those are commercial and regulatory tasks rather than tax-deduction questions.
After-the-Event (ATE) Insurance
After-the-event insurance protects against the downside if the case is lost. A typical ATE policy covers the client's exposure to the other side's costs (adverse costs) and the client's own disbursements if the claim fails. The premium is usually deferred and contingent: it is payable only on success, which is what allows a client of modest means to run a case at all. ATE is the piece that makes disbursement funding and conditional-fee arrangements viable, because it caps the client's downside.
The post-LASPO position is the point firms most often get wrong. Since the Legal Aid, Sentencing and Punishment of Offenders Act 2012 took effect on 1 April 2013, ATE premiums are generally not recoverable from the losing party on agreements entered into on or after that date. There are limited exceptions, the best known being an element of the premium relating to expert reports in clinical-negligence claims, but the general rule is that the premium comes out of the client's recovery rather than being added to the bill against the defendant. The interaction with recovered costs is covered in our guide to inter-partes costs recovery and VAT.
Deductibility of Funding Fees and Interest
This is the tax core, and it turns on the firm-versus-client borrowing line drawn above. The governing test is the wholly-and-exclusively rule: a trading expense, including interest and finance costs, is deductible if it is incurred wholly and exclusively for the purposes of the trade (ITTOIA 2005 s.34 for unincorporated firms, the equivalent provisions in CTA 2009 for companies). Finance costs of borrowing for the trade are deductible against trading profit.
So where the firm borrows to fund its own case outlays or working capital, the interest and fees on that borrowing are a deductible business expense, reducing the firm's taxable profit in the period. Where the client borrows, the loan and its cost are the client's, not the firm's, so there is no firm-level deduction at all; the firm is simply administering the client's money. With third-party litigation funding, the funder's return is a cost of the funded party rather than a straightforward interest deduction, so it should not be assumed to be a deductible finance cost in the firm's accounts. The practical discipline is to identify, for every funding arrangement, whose liability the funding cost actually is before deciding how it is treated. Our guide to law-firm cash-flow management sets the funding decision in its wider working-capital context.
VAT and SRA Treatment of Funded Disbursements
The headline is that funding does not change a disbursement's VAT character. Whether an outlay is a true disbursement, outside the scope of VAT and recharged with no VAT, depends solely on whether it meets all eight conditions in VAT Notice 700 section 25.1.1: in summary, that the firm acted as the client's agent in paying the third party, that the client received and used the supply, was responsible for and authorised the payment, knew a third party would supply, that the outlay is separately itemised, recovered at exactly the amount paid, and clearly additional to the firm's own supply. That test applies in exactly the same way whether or not the outlay was funded.
So a funded court fee that meets all eight conditions stays outside the scope of VAT. A funded outlay that fails the test, the classic example being a search fee the firm interprets and uses in its own advice (which, since the Brabners decision and Revenue and Customs Brief 6 of 2020, is part of the firm's taxable supply), remains standard-rated at 20% regardless of the funding. The general disbursement rules are set out in our guide to disbursements and their VAT treatment for UK law firms.
The funding fee or interest itself sits in a separate VAT box. The provision of credit or finance is an exempt financial supply under VATA 1994 Schedule 9 Group 5, so there is no input VAT on funding interest for the firm to recover. The firm's own onward charge for its legal services remains standard-rated. A firm should be careful before recharging a funding cost to the client as if it were a disbursement: the default is that the firm's charge for its services is standard-rated, and only a genuine pass-through that meets the eight conditions stays outside scope.
It is worth separating two ideas that are easy to merge. The VAT character of the underlying disbursement, whether it is a true disbursement or part of the firm's taxable supply, is decided by the eight conditions and is unaffected by funding. The VAT status of the funding itself, the lending, is exempt finance and carries no recoverable input tax. Neither of those changes the firm's core position: the firm charges output VAT at 20% on its own legal services. So a funded matter has, at most, three distinct VAT strands running through it, the firm's standard-rated fee, the out-of-scope genuine disbursements, and the exempt funding, and they should be recorded and reconciled separately rather than blended into a single recharge. Mislabelling a standard-rated cost as a disbursement because a funder paid for it is exactly the error the Brabners line of cases warns against.
Where Funded Money Sits: Client Account Versus Office Account
The routing of funded money is a regulatory question under the SRA Accounts Rules 2019, not a tax one, but it sits right next to the VAT analysis and is easy to get wrong. The principle is that the character of the money, not the fact that it came from a funder, decides where it goes.
Money advanced to fund disbursements that is the client's money (for example a disbursement loan drawn in the client's name to meet outlays the client is liable for) is client money under Rules 2 and 3 and must be held in the client account. Money that is genuinely the firm's own borrowing, used to finance the firm's working capital, is the firm's money and belongs in office account. Critically, SRA Rule 3.3 prohibits using the client account to provide banking facilities: every payment in, transfer or withdrawal must relate to the delivery of regulated services, and the account is reconciled at least every five weeks under Rule 8.3. Funded money must never be routed through the client account as a banking convenience for the funder or the client. The wider client-money discipline is covered in our guide to client money accounting for solicitors.
WIP, Lock-Up and the Funded Caseload
It is worth stating plainly, because firms sometimes assume otherwise: funding does not fix the tax-timing position. Work in progress is still recognised under FRS 102 as the firm obtains the right to consideration for its performance, and on conditional-fee and damages-based matters that right, and the revenue with it, is deferred until recovery is probable. Borrowing to pay the outlays does not bring forward the point at which the firm's own fee income is recognised.
So a firm can be fully funded on its disbursements and still carry a large WIP balance and a back-loaded, lumpy tax profile. Funding addresses the cash position; recognition is a separate question governed by the accounting standard. Indeed, a heavily funded contingent caseload can mask a high lock-up figure if the firm is not measuring its WIP and debtor days carefully. Reducing that lock-up is the core working-capital lever, and it is covered in our guide to law-firm lock-up reduction.
Worked Example: Firm-Borrowed Versus Client-Borrowed Funding
This example is illustrative only and is not advice; every arrangement turns on its own facts and documents.
A personal-injury firm runs a caseload of conditional-fee matters, each carrying roughly £3,000 of disbursements (medical reports, court fees, expert evidence) that are paid out early and recovered only on settlement, often two years later.
Scenario A: the firm borrows. The firm draws down a disbursement-funding facility in its own name, pays the outlays from the funded money, and repays the lender on each settlement with interest. Because the firm has borrowed wholly and exclusively for its trade, the interest and facility fees are a deductible business expense, reducing the firm's taxable trading profit. The disbursements themselves still have to pass the eight-condition VAT test: the genuine ones (court fees) stay outside scope, and any that fail (a search fee interpreted in the firm's advice) are standard-rated. The funded money used to pay the firm's own committed outlays is the firm's money and is administered through office account.
Scenario B: the client borrows. Instead, each client takes a disbursement loan in the client's own name. The loan and its interest are the client's cost, so there is no firm-level deduction. The funded money the firm holds to meet the client's outlays is the client's money: it is client money, held in the client account, and Rule 3.3 means it can only be applied to outlays on the client's matter, not run through the account as a banking facility. The VAT character of each disbursement is exactly the same as in Scenario A, because funding never changes whether something is a true disbursement.
The two scenarios deliver the same cash-flow benefit (the outlays are financed) but produce very different tax and accounting outcomes, which is why settling who borrows is the first step on any matter-funding arrangement.
Choosing Between the Products
Each product fits a different shape of work. Disbursement funding suits outlay-heavy volume work, where the cash drain is the cumulative cost of many small matters' disbursements. Third-party litigation funding suits large single commercial cases, where the scale and duration of the costs would otherwise be prohibitive. ATE insurance caps the downside on either, and is what makes a no-win-no-fee caseload viable by protecting the client against adverse costs and lost disbursements.
The decision is a net-cost-versus-cash-flow-benefit judgement, and it carries client-care and SRA disclosure obligations: the client must understand the funding and its cost, including how it affects the net sum they keep on success. The funding cost has to be weighed against the value of freeing the firm's capital and de-risking the matter, and that judgement is specific to the firm's caseload and balance sheet.
The products are also frequently layered rather than chosen in isolation. A volume personal-injury firm may run conditional-fee agreements, fund the disbursements through a disbursement-funding facility, and require each client to take out ATE cover, so that the firm's downside is contained, its outlays are financed, and its own fees are deferred to the win. A commercial firm, by contrast, may use third-party litigation funding on a single high-value claim and self-fund the smaller outlays. The accounting work is to keep the strands distinct: which costs are the firm's deductible finance costs, which are the client's, which outlays are genuine disbursements, and how the funded money moves through the ledgers. A clear matter-funding policy, applied consistently across the caseload, is far easier to support at the annual accounts and at the SRA accountant's report than a set of ad hoc arrangements decided matter by matter.
Practical Checklist
- Identify who borrows, the firm or the client, because that drives the deductibility and how the money is recorded.
- Treat firm-level funding interest and fees as wholly-and-exclusively deductible where the firm borrows for its trade; remember client borrowing is the client's cost, not yours.
- Keep the eight-condition disbursement test: funding does not change whether an outlay is a true disbursement or part of your standard-rated supply.
- Route funded client money correctly: client money to client account, no banking facilities (Rule 3.3), reconciled at least every five weeks (Rule 8.3).
- Recognise WIP under FRS 102 regardless of funding: funding fixes cash, not revenue recognition.
- Disclose the funding and its cost to the client as part of your client-care and SRA obligations.
- Coordinate ATE with the CFA or DBA, remembering the premium is generally not recoverable post-LASPO and usually comes from the client's recovery.
Matter-level funding is a powerful cash-flow tool for a litigation firm, but it interacts with deductibility, VAT and the SRA Accounts Rules in ways that reward a clear, documented approach from the start.
Speak to a Specialist
Disbursement and litigation funding can transform a litigation firm's cash position, but the tax, VAT and client-money treatment hinges on details that are easy to miss: who actually borrows, whether each outlay is a genuine disbursement, and how the funded money is routed. Speak to a legal-sector-specialist accountant who can review your funding arrangements, confirm the deductibility and VAT position, and make sure your client-money handling stands up to an SRA accountant's report.