Withholding tax and gross-up
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Boilerplate Anatomy™
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Withholding tax
A form of tax in which the payer of an amount of money (often interest payment or a dividend) is must withhold a portion of that payment and remit it to the tax authorities on the payee's behalf.
Certain kinds of tax are susceptible to withholding: taxes on interest and dividend payments, for example, as these are neatly determinative and may be clipped a pre-specified rate without any pause for thought. Other taxes are less suitable for withholding: General income tax obligations, the net levels of which depend on one's whole income over a year, for example. 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.
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). A gross up is meant to put the payee in the position it would have been had there been no withholding, so it gets he whole amount it initially expected. Grossing up may mean having to withhold an additional extra bit from the grossed up payment (and having to gross up that too, in an asymptotic slivers ad nauseam)
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
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.”
Set-offs versus withholding
The first thing to note is that this 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 a payee who might already own you something on account of some other business.
These things are worth looking at separately.
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”.[1]
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 types of payments are natural candidates for 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.
- Dividend withholding tax on the share investments (or manufactured equivalents)
- Interest withholding tax on loans and deposits
- Taxes on royalties
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 unpredictably, and whether a tax is due at all will depend on other things in the taxpayer’s life. For example, a shareholder that sells one share at a profit and another at a loss will, net, owe no tax, and seeing as tax collectors aren.t in the habit of rebating tax losses at source — what a utopian world we would live in if they did! — the intellectual argument for withholding taxes on realised profits is hard to make out.
Gross-up
Gross-up language is designed to put payees in the position they would be in if
Set-off
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
- ↑ Gratiutious The Hitch-Hiker’s Guide to the Galaxy ref, that. Sorry.