AT A GLANCE
- Tax rate: Depending on the contract, either the flat withholding tax (25%) or your personal income tax rate applies (§ 20 vs. § 22 German Income Tax Act EStG).
- Allowances: You can use either the saver’s allowance (€1,000) or the exemption threshold for services (€256).
- No tax exemption: Income from litigation funding is generally taxable in Germany.
- Impact investing: The social benefit (access to justice) does not currently result in any tax advantages.
- Documentation: Complete and accurate record-keeping is essential for loss offsetting and reporting to the tax office.
1. How Is Participation in Legal Cases Taxed in Germany?
Tax questions are rarely glamorous, but they determine what actually ends up in your bank account. Anyone who participates as a sponsor in a legal case and receives a share of the proceeds in the event of success should understand early on how these returns are classified for tax purposes. The basic principles are manageable. The details depend on the specific contractual structure, and this is where differences arise.
We explain these differences in detail below so that you can make the right decision for your own litigation funding activities.
Are These Capital Income or Other Income?
In litigation funding, the contractual structure determines which type of income applies. Since the tax burden can vary significantly between the flat withholding tax and the personal income tax rate of up to 45 percent, the correct classification is essential.
1. Income from Capital Assets (§ 20 EStG)
This classification applies if the financing is legally considered a provision of capital in exchange for compensation.
- Tax rate: Flat withholding tax of 25 percent plus solidarity surcharge and, if applicable, church tax.
- Requirement: There must be a “capital claim” where compensation is paid for the temporary provision of capital.
- Source: § 20 para. 1 no. 7 German Income Tax Act (EStG)
2. Other Income (§ 22 EStG)
This residual category applies when the financier’s contribution is not primarily the provision of capital, but rather the assumption of litigation risk or the performance of a service.
- Tax rate: Your personal income tax rate, which can exceed 25 percent at higher income levels.
- Requirement: The income must result from a “service” that cannot be assigned to another category of income such as business income or capital income.
Source: § 22 no. 3 German Income Tax Act (EStG)
When Does Withholding Tax Apply?
Withholding tax applies when income from capital assets is generated. The tax rate is a flat 25 percent plus 5.5 percent solidarity surcharge, resulting in an effective rate of approximately 26.375 percent, excluding church tax. For investors whose personal tax rate is below 25 percent, the so-called favorable tax assessment can be requested. In this case, the tax office applies the lower individual tax rate upon application.
What Difference Does the Contract Structure Make?
A significant one. Two sponsors who are economically doing the same thing can be taxed very differently if their contracts are structured differently. Anyone participating as a sponsor on a platform such as AEQUIFIN should carefully review the specific contractual documents and, if in doubt, consult a tax advisor.
2. Which Investments Are Tax-Free and Does This Apply to Litigation Funding?
Only very few types of investments are completely tax-free in Germany:
- Riester and Rürup pensions: Tax-free during the accumulation phase, taxable during the payout phase
- Occupational pension schemes: Tax-free during the contribution phase
- Certain life insurance policies: Under specific conditions, such as a minimum term of 12 years and payout after age 60, half of the returns may be tax-free
- Capital gains from shares purchased before 2009: Existing holdings from that period remain tax-free
For returns from participation in legal cases, there is no general tax exemption.
Can You Save Taxes with Litigation Funding?
Litigation funding itself does not directly reduce taxes. However, there is a relevant aspect to consider: if a funded case is unsuccessful, the invested amount is lost. Whether and how this loss can be deducted for tax purposes depends on the contractual structure and the classification of the income.
Which Allowances Apply to Alternative Investments?
Tax relief depends largely on whether your returns are classified as capital income or other income. A change in income classification affects not only the tax rate but also the available allowances.
1. Saver’s Allowance for Capital Income (§ 20 EStG)
If returns, for example from litigation funding structured as a loan, are classified as capital income, investors benefit from the saver’s allowance.
- Amount: Since 2023, this amounts to €1,000 per person, or €2,000 for jointly assessed married couples.
- Effect: Up to this limit, returns remain tax-free. However, the deduction of actual income-related expenses is legally excluded.
Source: § 20 para. 9 German Income Tax Act (EStG)
2. Exemption Threshold for Other Income (§ 22 EStG)
If returns are instead classified as income from services, the saver’s allowance no longer applies.
- Amount: Only an exemption threshold of €256 per calendar year applies.
- Effect: Important distinction. This is not an allowance but a threshold. If the €256 is exceeded by even one euro, the entire amount becomes taxable from the first euro.
- Advantage: Unlike capital income, actual income-related expenses such as legal or advisory costs can be deducted to reduce the tax burden.
Source: § 22 no. 3 German Income Tax Act (EStG)
3. What Are Impact Investments and How Are They Taxed?
What Are Impact Investments?
Impact investments are capital investments that aim not only for financial returns but also for a measurable social or environmental impact. This impact is not a side effect but an explicit investment objective. Litigation funding falls into this category. Participating in legal cases creates direct social value by enabling access to justice for individuals who might otherwise not be able to afford it.
More on this: Litigation funding as an impact investment
Who Coined the Term Impact Investing?
The term was introduced by the Rockefeller Foundation in 2007. Since then, institutions such as the Global Impact Investing Network (GIIN) have developed standards and measurement frameworks. In Germany, impact investing is gaining importance primarily among institutional investors and family offices, but increasingly also among informed private investors.
Are Impact Investments Tax-Privileged?
In Germany, no. There is no legal provision that generally grants tax advantages to impact investments. Tax treatment depends solely on the type of income, not on the social purpose of the investment. An exception applies to donations to charitable organizations, but this is structurally different from an investment with an expected financial return.
4. What Are the 3 Types of Sponsors in Litigation Funding and How Do Their Tax Obligations Differ?
Private Individuals as Sponsors: What Applies for Tax Purposes?
For private individuals, the rules of the German Income Tax Act apply. Returns are classified either as capital income, subject to a flat withholding tax of 25 percent, or as other income, taxed at the personal income tax rate. The saver’s allowance of €1,000 per year can be applied proportionally.
Companies as Sponsors: What Applies for Tax Purposes?
For companies such as a GmbH, AG, or partnerships, different rules apply. Returns from investments are taxed within the framework of corporate income tax or income tax, depending on the legal structure. The flat withholding tax does not apply. Losses may be offset against other business income, depending on the circumstances.
Foreign Sponsors: Special Considerations for DACH Platforms
Sponsors from countries such as Switzerland or Austria who invest in German legal cases via a German platform must comply with the tax laws of their country of residence. In addition, double taxation agreements between countries may be relevant. Cross-border tax advice is strongly recommended for foreign sponsors.
IN JUST 5 MINUTES:
In just 5 minutes: Become a sponsor – Your entry into attractive litigation financing opportunities
1
Register as a sponsor
2
Select a case
3
Set the bid amount and quota
4
Provide PayPal or credit card details
5
Participate in the litigation proceeds
5. What Is the 5-10-40 Rule and Is It Relevant for Litigation Funding?
What Does the 5-10-40 Rule Apply To?
The 5-10-40 rule originates from European investment fund law under the UCITS regulation. A single issuer may account for a maximum of 10 percent of the fund’s assets, and all issuers with more than 5 percent each may together account for no more than 40 percent. Its purpose is diversification and risk spreading within regulated investment funds.
Does the 5-10-40 Rule Apply to Individual Legal Cases?
No. The 5-10-40 rule applies to regulated UCITS funds, not to direct investments in individual legal cases. Private individuals participating as sponsors in a specific case via a platform such as AEQUIFIN are not subject to this regulation. However, the underlying principle of diversification as a risk management strategy remains relevant.
6. Practical Tax Tips for Sponsors
How Should I Document My Participation for Tax Purposes?
Proper documentation is essential. Sponsors should keep the following records:
- The full investment agreement with all terms and conditions
- Proof of the invested amount and the date of payment
- Settlement statements in the event of success, including amount received and date
- Correspondence with the platform on tax-related matters
- In the event of a loss, proof of the final conclusion of the case
What Happens Tax-Wise if a Case Is Lost?
If a funded case is unsuccessful, the invested amount is lost. Whether this loss can be claimed for tax purposes depends on how the income is classified. For capital income, losses may be offset against gains under certain conditions, but only within the same loss offset categories. The exact treatment is complex and depends on the individual tax situation.
When Is Tax Advice Worthwhile for Alternative Investments?
Tax advice is recommended especially when:
- Returns exceed the saver’s allowance of €1,000
- Multiple investments are made across different cases
- Losses occur and are intended to be used for tax purposes
- Capital is invested through a company structure such as a GmbH or holding
- Investments are made as a foreign resident or from abroad
