Tax Gross-Up

A tax gross-up is an increase in a payment made so that, once tax has been deducted from it, the recipient is left with the amount it was originally promised. The payer bears the cost of the tax instead of the recipient. Gross-up clauses are standard in loan agreements, bond terms, derivative contracts, licence and service agreements, and some employment packages, wherever a payment may be reduced by withholding tax before it reaches the person entitled to it.

The idea is most common in cross-border finance. A lender in one country prices a loan on the assumption that it will receive interest in full; if the borrower's country imposes interest withholding tax, the lender's return falls unless the contract shifts that cost back to the borrower. A gross-up clause does exactly that, and it is usually paired with other terms that limit how far the obligation goes.

Because the tax is charged on the increased payment, not on the net amount, the payer cannot simply add the tax rate to the amount due. The standard calculation is:

Here $t$ is the withholding tax rate, written as a decimal. Suppose a borrower owes interest of 100,000 and the local withholding rate is 20%. The grossed-up payment is 100,000 divided by 0.80, which is 125,000. The borrower withholds 20% of 125,000, which is 25,000, pays it to the tax authority and sends 100,000 to the lender. The borrower's true cost of the interest is therefore 25% higher than the stated amount, not 20% higher.

If a double taxation treaty reduces the rate to 10%, the gross payment falls to about 111,111 and the extra cost to about 11,111. This is why borrowers care whether their lenders qualify for tax treaty relief.

The clause takes slightly different forms in different markets:

• Loan agreements. Syndicated loans normally require the borrower to gross up payments, but only for lenders that were entitled to receive interest free of withholding when they joined the facility. A lender that loses that status through its own actions usually loses the protection.
• Bonds. International bond terms often oblige the issuer to pay additional amounts if withholding is imposed, and give the issuer a right to redeem the bonds early if a change in tax law triggers the obligation.
• Derivatives. The standard master agreement used for over-the-counter derivatives requires a payer to gross up for certain taxes and allows the affected party to terminate transactions if a change in law creates a new withholding.
• Commercial contracts. Royalty, service and licence agreements may gross up for withholding on cross-border fees, often after negotiation over which side takes the risk.
• Employment. An employer may gross up a bonus, relocation payment or benefit so that the employee receives a stated amount after income tax and payroll deductions.

A gross-up obligation is rarely unconditional. Contracts usually exclude taxes on the recipient's overall net income, taxes that arise because the recipient failed to supply forms or a tax residency certificate, and withholding under regimes such as FATCA, where the deduction results from the recipient's own compliance status. Recipients are commonly required to cooperate in completing any procedure that would allow payment without deduction.

Two further mechanisms sit alongside the clause. A tax indemnity covers tax charged directly on the recipient in connection with the contract, as opposed to tax withheld from a payment. A tax credit provision requires a recipient that later obtains a credit or refund for the withheld tax, for example through double taxation relief at home, to pass the benefit back to the payer, so that the recipient is not compensated twice. Many agreements also contain a mitigation clause under which the recipient must take reasonable steps, such as booking the loan through another office, to reduce the cost.

For the payer, the grossed-up amount is the real cost of the payment and is recorded as such: interest expense for a loan, staff cost for an employee benefit. The tax withheld is a liability to the tax authority until it is paid over. For the recipient, the taxable income is normally the gross payment, with the withheld tax available as a credit where the law allows. Whether the payer may deduct the extra cost when calculating its own taxable profit depends on local rules.

Gross-up clauses move risk without removing it. They can make borrowing sharply more expensive when tax law changes, which is why issuers insist on early redemption rights and borrowers on the right to prepay or replace an affected lender. Some jurisdictions restrict or disregard clauses that shift a tax to a person other than the one the law intends to bear it, and tax authorities may treat tax paid on someone's behalf as further taxable income. Disputes also arise over whether a recipient is the beneficial owner for tax purposes and so entitled to a treaty rate, a question that the contract cannot settle on its own.

• OECD: Tax treaties