Law firm finance 101 – Tools to limit interest expense on third party funding
18 May 2020
It is our recommendation that this article is read in conjunction with an earlier piece published on Taurus Capital’s website, titled, the Interest Tax Shield, dated March 16th, 2020.
Funding your law firm
To secure growth and earnings for a law firm and its partners, managing partners need sufficient capital to fund the activities related to dispute resolution over an extended period. This is due to the protracted and capital-intensive nature of personal injury litigation, which add tangible and intangible expenses to the day to day working capital requirements of a law firm. Legal practitioners need to make use of experts, advocates and witnesses to provide their independent specialist services in most litigation matters. These services are expensive and taken on risk, with no guarantee that they will recoup these expenses promptly or, unfortunately, at all.
This can often jeopardise the relationship between the firm and its experts, due to the necessitation of extended payment terms, which also carries the implicit risk of non-payment to the expert for his/her services. Law firms need to examine avenues of raising sufficient capital and cashflow, either by investing the partners’ own funds (years of accumulated profits from the firm) or by way of exploring alternative/third party funding (debt).
As mentioned in an earlier article on the Interest Tax Shield, through shielding a fraction of your taxable income with interest payments(debt), you can save cashflow each calendar month, boosting the bottom line of your firm.
In the event that a law firm opted for debt funding, decision makers need to decide how to treat the remainder of the interest expense not protected by the tax shield stipulated in Section 24J of the Income Tax Act of 1962. The answer lies in making provision for your debt expense within the contingency fee agreements that will be concluded with your clients. This article will detail how to combine the Interest Tax Shield and Incidental Credit to limit your firm’s interest expense on third party funding.
Understanding the contingency fee agreement
In this segment, we examine best-practice structuring of contingency fee and mandate agreements to ensure a sustainable arrangement that manages the cost of disbursements incurred by the firm on behalf of their contingent clients. This agreement regulates the relationship between the legal practitioner and the client. The Legal Practice Council oversees this agreement in line with its mandate to handle all of its members’ dealings with the public.
Legal Practice Council (LPC) on Contingency Fee Agreements
On 4 October 2019, the Legal Practice Council published its Rules pertaining to the Contingency Fees Act under Legal Practice Council Notice, 525 of 2019.
The Notice confirmed that the “Contingency fee agreement shall be in the form as prescribed by the Minister of Justice under Section 3 (1) (a) of the Act, being the form published in Government Notice No R547 of 23 April 1999 (Government Gazette No 20009) as per Form 1 annexed to these rules or any subsequent Form that might be promulgated in terms of Section 3(1) of the Act from time to time.”
How to address funding as part of disbursements
The Notice goes on to clarify a very important aspect of a contingency arrangement, whereby “The contingency fee agreement shall record the manner in which disbursements made or to be incurred by the legal practitioner on behalf of the client shall be dealt with.”
It states that “If the client is responsible for funding disbursements, the legal practitioner shall account to the client from time to time in respect of monies disbursed during the conduct of the proceedings.
“If the legal practitioner has undertaken to pay or incur disbursements on behalf of the client pending the conclusion of the proceedings the legal practitioner shall be entitled to charge interest on monies so disbursed, provided that this is done lawfully by the legal practitioner, in particular in accordance with the provisions of the Prescribed Rate of Interest Act 55 of 1975, and/or in compliance with up the provisions of the National Credit Act 34 of 2005.”
Incidental Credit
The National Credit Act 34 of 2005 (NCA) states: “’ incidental credit agreement’ means an agreement, irrespective of its form, in terms of which an account was tendered for goods or services that have been provided to the consumer, or goods or services that are to be provided to a consumer over a period of time, and the following applies: …
(a) a fee, charge or interest became payable when payment of an amount charged in terms of that account was not made on or before a determined period or date;”
The NCA makes provision for legal practitioners to charge interest on their clients’ accounts, in the event that the legal practitioner paid for the disbursements on behalf of the client, and the payment was due, before a predetermined time. The predetermined time generally means after the legal practitioner successfully negotiated a settlement against the Road Accident Fund or obtained a court order against the Fund.
If the law firm is only a supplier of incidental credit, one need not be registered as a credit provider as stated in the NCA. Before the amendment in the NCA, section 40 imposed two registration conditions on persons involved in lending money. However, with the introduction of the National Credit Amendment Act(NCAA), we saw the deletion of the 100 credit agreement requirement.
On 11 May 2016, the Minister of Trade and Industry announced in terms of section 42(1) of the NCA, its determination pertaining to the threshold for a credit provider registration in the Government Gazette with notice number 39981, from R500 000,00 to R0,00. The Minister of Trade and Industry further announced the publication of new Regulations on Review of Limitations on Fees and Interest Rates (Government Gazette No 39379). The review amended and/or added new regulations to Regulation 42, 43, and 44 of the NCA.
The current interest rate on an incidental credit agreement is 2% (two percent) per month which accrues to 24% (twenty-four percent) per annum which can be charged on default payments within an incidental credit agreement.
Prescribed Rate
In terms of Section 105 of the NCA, the Minister, in consultation with the National Credit Regulator, prescribes the interest rates which can be charged in terms of an incidental credit agreement. This interest rate is of great significance to the attorney as it would yield a larger return on investment, compared to the lower fees associated with a registered credit provider lending cash to its clients. As stated above, the current prescribed interest rate on an incidental credit agreement is 2% per month, or simply put, 24% per annum. Compare this rate to the 10,25% interest rate per annum prescribed by the Minister in terms of other debts that bears interest, given by a registered credit provider.
Case Study
Gamma Delta Inc is a medium-sized personal injury law practice. Karen Delta, the Managing Director, wants to grow her practice by taking on additional cases. She recognises that good relationships with the firm’s third-party experts is key to both successful litigation as well as the growth of her practice. All of the firm’s cashflow is tied up in operational overheads and there are insufficient funds to finance the R1 million that Karen estimates they’ll need to cover in terms of disbursement costs associated with the additional workload.
Considering her options, Karen comes to the following conclusions:
She could borrow the funds in her personal capacity and then invest the proceeds directly into her practice, OR
Gamma Delta Inc could borrow the funds directly through a working-capital loan. This option is intriguing for two reasons. Firstly, the facility would be eligible for the interest tax shield. Assuming an interest rate of 30% and a tax rate of 28% in both cases, the after-tax interest rate in option 2 is only 21,6%. This tax benefit equates to a saving of R84 000 per annum.
Further to this, Karen could agree with her clients that incidental credit would apply to their matters, due to her funding the disbursements on behalf of the clients. A large portion of the remaining R216 000 in interest debt could successfully be allocated to the appropriate client’s accounts, due to the parties entering into an incidental credit agreement. The exact savings amount will vary due to the timelines associated with every matter.
Conclusion
By taking on a loan facility from a third-party provider, Gamma Delta Inc could successfully take on additional matters and increase their revenue without tapping into their own savings. Depending on the deal flow and case management of Gamma Delta Inc, Karen could negate almost the entire interest amount owing on the loan facility, by making use of the interest tax shield and managing her incidental credit agreements.
The structuring of funding for your legal practice is all-important and requires careful consideration and consultation with your accountant/a registered tax professional as well as a legal practitioner to fully understand and amplify the benefits of the interest tax shield.
Disclaimer: This article is for educational purposes only and should not be misconstrued as financial or tax advice. Consult an accountant or registered tax practitioner for advice specific to your financial situation.
See also:
- Law firm finance 101 – Interest tax shield
- Law firm finance – The cash gap
- Requirements for providing guarantees – Financial assistance to companies
