Withholding tax and gross-up

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Withholding tax

Everyone knows one is liable to tax on one’s income: this is in the “rice-pudding” category of “things that are deducible from first principles”.

But the taxperson has ways of extracting its slice of the action. It can wait till you file your tax return, or it can deduct at source — pay as you earn — or it can oblige your counterparties to deduct as they pay you. This is called “withholding” — the payer remits the tax and pays it on your behalf.

Certain kinds of tax are susceptible to withholding. These are broadly characterised as income payments: compensation for your investment, capital, or the fruits of your labours as it were. So: PAYE income tax; taxes on interest, dividends and royalties are neatly determinative and may be clipped a pre-specified rate without any pause for thought

Other taxes are less suitable for withholding:

These can’t realistically be claimed by withholding, but that won’t stop tax attorneys avoiding non-existent doubts about the risk that some revenue authority, somewhere in the world, contrives some way of doing it.

Interestingly, Americans particularly see withholding taxes as specifically taxes imposed on non-residents that are “clipped on their way out the door” to stop foreigners making off with US tax revenues and never paying them back later. So some don’t consider income tax a withholding tax as such. But it is.

Other payment types, such as purchase and sale amounts, fees for services and so on, tend not to be withheld at source, basically because they are too irregular, too unpredictable, and whether a tax is due on the flow at all will depend on other things going on in the taxpayer’s financial life. For example, capital gains: the amount of tax depends on the historical price of acquisition and the time held, so the necessary certainty to apply a standardised rate is not there.

ISDA Master Agreement

The ISDA Master Agreement has all sorts of provisions about withholding, gross up and what kinds of taxes count (Indemnifiable Taxes), which includes a fantastic quintuple negative.

Gross-up

Wherever one finds a withholding tax — or a risk of one — one will find legal provisions compelling the payer to gross up the withheld payment (or absolving it from doing so).

What are they?

Tax gross-ups are designed to shift tax liability from the payee so payer bears the full cost of the tax and payee suffers no loss of income. You might expect this in cross-border transactions, where the source country withholds on payments to nonresidents, thereby preventing tax avoidance. But if the recipient’s country also taxes the income there may be a double taxation scenario. A tax gross-up can compensate the recipient where there is no tax treaty between the countries to provides an exemption. You may see a gross-up in a domestic deal where the payee requires a certain level of income regardless of the tax consequences.

How they are articulated

You will often see time-tested, careworn tax language along the following lines:

“Payments must be made without set-off, counterclaim, deduction or withholding unless required by law in which case the payer shall pay such additional amounts as will result in the receipt by the recipient of the amounts which would otherwise have been payable by payer to recipient under this Clause in the absence of any such set-off, counterclaim, deduction or withholding.”

The fussy construction “unless required by law” has become canon, but it is tiresome. The number of optional withholding taxes in the world is surely small — but not zero, we understand — so what this counsels is as follows: “if you have a choice not to withhold, take it; if you do not; gross me up.”

A lot of the time you will have gross-up clauses that are quite irrelevant: there is no withholding tax on the payment in question, and none ever likely (it is not in the nature of an “income on investment of capital or labour”), but this will not stop diligent legal eagles observing Casanova’s rule.

Set-offs versus withholding

Note also that this boilerplate mixes two quite distinct ideas: tax on one hand — one’s liability to The Man, as it were — and set-off on the other: whether and if so how one should flatten out one’s aggregate liability to the payee if it happens already to owe you something on account of some other business altogether.

See also

• FATCA Amendment - ISDA Provision
• Withholding tax
• Indemnifiable Taxes
• Gross-Up in the ISDA Master Agreement
• Deduction or Withholding for Tax in the ISDA Master Agreement