We’re no strangers to levyYou know withholding rules and so do I:Some tax commitment’s what I’m thinking ofYou wouldn’t get this from any other guy.I just wanna say I’m imputatingGotta make you understand:

Never gonna gross you upNever gonna write you downNever gonna reach around and withhold youNever gonna make you cryNever gonn’ indemnifyWhat they can’t recharacterise can’t hurt you.

We’ve known each other for so longI sealed your deed but you’re too reserved to stamp itInside we both know what’s been going onWe goin’ away, yes we’re gonna glamp itAnd if you ask me, I’m deferringMy cashflows to the next financial year:

Never gonna gross you upNever gonna write you downNever gonna reach around and deduct youNever gonna make you cryNever gonn’ indemnifyWhat they recharacterise will hurt you.

—Rick Astley’s IFA

And to this end they built themselves a stupendous super-computer which was so amazingly intelligent that even before its databanks had been connected up it had started from “I think, therefore I am” and got as far as deducing the existence of rice pudding and income tax before anyone managed to turn it off.

—Douglas Adams, The Hitch-Hiker’s Guide to the Galaxy

We all know we are liable to tax on our income: this is in the “rice-pudding” category of “things that are deducible from first principles”. Now, broadly speaking, the taxman has three ways of extracting his slice of the action from the torrent of money sloshing around the financial system: he can take tax away, he can add tax on, or he can ask you to account for it later.

Taxes he takes away, we call “withholding taxes”. Taxes he adds on, we call “consumption taxes” Generally, withholding and consumption taxes we call “indirect taxes” because a tax burden that ultimately falls on a person such as an employee, investor or purchaser is collected via an intermediary such as an employer, bank or retailer.

The alternative is direct tax, which you pay yourself. Generally, you do this at the of the year by means of a tax return.

Withholding taxes

Withholding taxes are deducted from payments owed by intermediaries to the taxpayer. Here the intermediary remits the tax directly to the tax department on the taxpayer’s behalf.

The best example of a tax withholding is P.A.Y.E. income tax. Withholding is often also applied on income payments under financial instruments — dividends, interest payments, but beyond that is pretty rare, for reasons I will come on to.

Consumption taxes

Consumption taxes are added on to the price of goods and services a taxpayer buys, so the seller acts as an intermediary, collecting the tax and remitting it to the tax department on the taxpayer’s behalf.

The most common examples of consumption taxes are sales taxes, goods and services taxes and value added taxes — these are really just different names for the same thing.

(For spods: the technical difference between VAT/GST and sales tax is that the former are payable at all points in the payment chain, whereas the latter are only payable on the final retail sale, though intermediaries paying VAT/GST can reclaim VAT on inputs, so the net effect is the same.)

Direct taxes

Or, as a last resort, the taxman can ask a taxpayer to give a full account, at the end of the year, for all her financial affairs by means of an annual tax return. Here the taxpayer must tot up all her earnings, incomings, outgoings, and credits she has received for taxes already withheld or surcharged, any taxable events, depreciations, imputation credits, concessions, benefits, exemptions and reliefs — and then apply the labyrinthine tax rules to it. For most of us indentured wage servants, P.A.Y.E. takes most of that pain away.

For those outside the cosy embrace of formal employment, it is quite the process to work out, what ultimately must be rendered unto Caesar. This is a bane — it is a proper ball-ache — but yet a boon, because beyond P.A.Y.E. your tax liability falls on your net profit at the end of the year, so you can deduct your operating expenses from your income. You only pay tax on the difference, whereas a wage-earner pays tax on her gross income and cannot deduct her costs of providing her labour (her suits, bus ticket and so on).

Note this difference: it is important when we get to the question of gross-up.

Why tax departments like indirect taxes

Tax departments like indirect taxes. They get paid sooner and more reliably, and if there is an overpayment, it is someone else’s problem to figure it out, prove it and ask for the money back. And putting the obligation on a payer at the point of payment means it is more likely taxes get paid.

Equally, it is easier for a working stiff to not have to worry about receiving extra money, sitting on it, not “losing” it and then remembering to pay it when due at the end of the year. Having the whole ugly business handled automatically is, for most of us, a blessing.

Likewise, hoping tourists pay taxes they owe on goods they bought and took home, or foreign investors pony up taxes owed on local interest and dividends is a bit wishful: it is better to take it first and let the taxpayers ask any questions they may have later. The tax department isn’t going anywhere: tourists you may never see again.

The problem with indirect taxes

This is all very well in these limited case where the final tax amount due is a determinable percentage of a given payment, as it is for wages, investment income, and certain types of retail sales.

But most tax-relevant payments flying around the financial system aren’t like that. Payments made for goods and services between businesses don’t very well reflect those businesses’ final tax obligations. In fact, they bear no relation to them at all.

A service sold today for £100 might cost the provider £95 to render. The provider should not have to pay tax, therefore, on that whole £100, but only on its net profit — in this case, £5. If withholding were imposed, the payer would be paying a £20 withholding in respect of a likely tax of just £1— being 20% of the actually realised £5 profit.

But even that per-item net profit amount is variable. It is not determinable at the time the payment is made. The profit on a given transaction, at the point of payment for the service is a mystery. It will change from day to day as market conditions, supply, demand, and input costs fluctuate.

Sometimes the provider will make a big profit. Sometimes it will the service at a loss. But in any case it won’t immediately know what its net profit on a given item is — and of course net profit is not itemised and determined per unit sold in any case. So business-to-business payments are hardly a suitable topic for indirect taxes which, by nature, are fixed, and meant to be a close-to-final estimate of the total tax payable on a given transaction. Hence: withholding taxes are generally not imposed on sales, and intermediaries are exempted from consumption taxes.

Why salaries and investment income are different

Salaries and investment income are the two unusual cases where indirect taxation, levied at the point of payment, is practicable.

Since, generally, an employee can’t set her income off against her expenses — the tax is effectively levied on her gross income, not her “net profit” from her employment — she can’t write off her power-suits, penthouse suite, Maserati lease, luxury yachts and all-expenses paid week-long “conferences” in the Swiss Alps against her taxable income, as the self-employed gladly do.

This is why, for the average working stiff, P.A.Y.E. is an effective and unobjectionable way of paying tax. There is little benefit to being paid money you are just going to have to pay back to the taxman at the end of the year.

Investment income, on the other hand, is suited to indirect taxation because it is already a “net return” on a given transaction. Take a loan: I give you a million quid; you give it back. Expense-wise, we are flat. Assuming you remain solvent, the difference on the transaction is the interest you may me. That is my net return from the transaction. I do not incur any other costs specifically relating to this loan that I would not be incurring anyway.

Taxing authorities are especially fond of indirect taxes on “cross border” payments from persons in their jurisdiction to persons outside it. Tax authorities have some, er, means of persuading their own citizens to pay their taxes. These are strangely ineffective against foreigners who do not have a meaningful presence — meaning assets — somewhere the tax authorities can conveniently park their tanks.

Why all this matters: finance contracts vs commercial contracts

All commercial lawyers are alike. Each tax lawyer is unique in her own way.

Buchstein, Anna Carriedinterestova

Now the Jolly Contrarian’s sophomore ramblings about income tax are all well and good — if you have made it this far, well done and thanks for bearing with — but you may be wondering what all this has to do with negotiating contracts.

It is this: tax, insofar as it presents in legal contracts, baffles most practising commercial lawyers. They don’t care about it, they don’t understand it and they are not very good at it. They find people who are good at it to be weird.

For commercial lawyers tend to be very much of a piece. They all enjoy the same things, talk in the same mannered way and do the same sorts of things — dull things — at weekends. You know them when you see them, by their dreary dress, dowdy haircuts, awkward dispositions and the peculiar mannerisms commercial lawyers affect when two or three gathered together. You know to avoid them at dinner parties: they make terrible “middlers”.

Tax lawyers, on the other hand can be quite exciting, but often in alarming ways. They do not have a common type the way commercial lawyers do: among them will be balloonists, bikers, bee-keepers, wing-suiters, Michelin-starred chefs and ornithologists. They enjoy doing odd things at the weekend. They make for interesting middlers, but risky ones: it will be a memorable evening, but do not be surprised if a fight breaks out. Tax lawyers are evenly distributed across the, well, spectrum, and united only by differences and the extent to which they are highly, if reluctantly, valued by us commercial lawyers for the unique shafts of light they cast across our impenetrable swamps of text.

Commercial lawyers don’t like it when a counterparty objects to the “Taxation” boilerplate in our standard contract. It seems like poor sportsmanship, or dirty pool: taking good-natured argument to unsavoury extremes. If that has happened to you, and you don’t have a tame tax lawyer — or you can’t bring yourself to call a wild one — the Jolly Contrarian is here to help.

For the tax issues arising under finance contracts, on one hand, and commercial contracts, on the other, are very different.

Finance contracts

Financial contracts, as the name implies, involve the allocation of capital. An investor provides money (or money’s worth), the customer repays it and, in the meantime, pays income. As discussed above, the income earned from this investment — be it in the form of interest or dividend or some other derivative payoff — does represent, more or less, the “lender’s” net profit on the transaction. Net profits are the sorts of things on which local tax authorities are apt to impose withholding taxes.

Since a withholding tax is quite likely — even if it doesn’t exist now, it could easily be imposed later, and many finance contracts contemplate multiple transactions in multiple jurisdictions stretching into the unknowable future — the question arises whether the borrower will be asked to gross up that withholding tax. The answer — we’ll come to why — is usually “yes”. As to whether they should agree, see the premium section.

Commercial contracts

It is better to have taxed and rebated, than never to have taxed at all.

—Otto Büchstein, op cit

Providers of non-financial goods and services — techbros, restaurant suppliers, bloggers — call these critters “purveyors” — do not freely allocate money. Instead, they dole out tech services, fish or nuggests of unfathomable wisdom, for which they are paid small but regular sums.

Payment for each item is a purveyor’s total revenue for the transaction, not its net profit. A purveyor is not, therefore liable to pay tax on an entire receipt, but only the portion representing its clear profit when all is said and done. Since that is unknown and variable, payments made under a commercial contract are not, generally, suitable for tax withholding.

As discussed above, the amount of tax payable on the transaction — it tax is payable at all — depends on a raft of other things that, at the time of payment not even the taxpayer knows. So generally, most sensible jurisdictions do not withhold on payments made under non-financial commercial contracts.

Some, ah, “sensible” jurisdictions do impose withholding on whole service payments, especially those owed to non-residents, presumably on the theory it is better to have taxed too much and rebated, than never to have taxed at all.

Though there are sometimes ways to recoup these overpayments, they are often painful and can take years and quite a lot of intermediary expense — so sucking it up, or not doing business at all in those jurisdictions — are often better options.

In any case, grossing up a clumsily-imposed withholding on a service payment makes little sense. Talk of grossing things up brings me to the topic of —

Gross-up

Gross-upɡrəʊs ʌp (n; v.)

A contractual obligation to increase the amount of a due payment so that, after withholding, the recipient receives the originally intended sum net of the withholding tax, meaning the payer assumes the recipient’s tax burden and covers the tax.Example:X owes Y £100, subject to a 20% withholding.X “grosses up” the payment and pays £125.Y receives £100 after the withholding.

In very simple essence, a tax gross-up shifts a payee’s tax liability to a payer. It is not just a procedural matter but an economic fundamental of the deal. To keep it simple, let’s take the case of an interest payment under a loan — but the same principles apply to bond coupons, swap payments, manufactured dividends and so on: more or less any “debt” style income spinning off a financial instrument.

An interest payment on a loan is taxable income for the the lender. By grossing up, the borrower agrees to pay that tax — and a bit more: there is also a pro-rata withholding on the “grossed up” portion — to make sure the lender is paid the whole amount it would have received had there not been a tax.

It is, largely, a “cross-border” thing: gross-ups generally happen when the interest payment originates, and the tax is therefore due, outside the lender’s jurisdiction, and therefore the tax, even though imposed on the lender, is a function of who — and where — the borrower is.

The lender — usually a financial institution who is is allocating its own capital at the borrower’s request and for its benefit, remember — has the bargaining power. It is saying:

“My price for this loan is 5%. I don’t care whether or not your tax authorities required you to withhold tax on your interest payments; I just want my 5%. So whatever happens, you have to pay me that. If your tax authorities make you withhold some tax on my behalf, so be it: it is up to you to pay that but, in any weather, you must pay me my 5%.”

Since the lender is, Q.E.D. not tax resident in the borrower’s jurisdiction, it will reason, correctly, that, firstly, it will have to pay tax on its realised profits in its home jurisdiction anyway and, secondly, while it might be able to claim a rebate or seek relief against double taxation by the borrower’s tax authorities — but then again, might not — this will be painful, expensive, slow and not assuredly successful. It is more trouble than it is worth. So it says, “borrower, the cost of you getting this loan is you agreeing to wear the risk of withholding in your jurisdiction”.

It is easier for the lender to say,

“Stuff that tax reclaiming process for a joke: just gross me up, and if you don’t like it, go find someone else to lend to you.

You may see a gross-up in a domestic deal where the payee requires a certain level of income regardless of the tax consequences — unusual, but the negotiation dynamics will be the same.

How gross ups 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.”

In a nutshell:

You must render amounts due under this agreement without set-off or deduction unless there is a mandatory withholding in which case you must pay such additional amounts so that the amount I receive is the full amount that stated under the contract without accounting for the necessary 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.”

Gross-up SNAFU

“There are no tax specialists in foxholes.”—William Tecumseh Shearman

Now, as I mentioned at the top: to a contracts lawyer — especially one dug into a negotiation foxhole — questions of taxation are, in equal parts, baffling, terrifying and sacred. There is, therefore, an honour code: the unwritten rule of commercial combat is that a man doesn’t fool around with another man’s tax boilerplate. Those Fruty knyghtes of the Isdere recognise in each other’s tax covenants the word of the godhead, dispensed in ancient times like tablets on the Mount to a grateful populace.

But the aeons intervene: over the centuries clarifications are added; wording is polished; templates are updated to reflect market developments and new regulations. The nature of this lexical drift is evolutionary: there is no ground-up redesign (that would be sacrilege!) Nothing is taken away (that would be dangerous!) Provisions suiting one type of contract are copied mindlessly across to precedents for others, in the name of consistency, safety and form. As time passes, the knowledge from which those mystical runes were forged is lost to the younger generations. Practical guidance becomes immutable lore.

For those inclined — or obliged to take contract wording literally, this can be fraught. Especially those against whom these windy tracts could be enforced.

Not always: much gross-up verbiage is quite irrelevant: there is no withholding tax on a service payment, and none is likely to be imposed, but this will not stop inhouse teams insisting on it in their contracts as a matter of ditch-dying urgency. But depending on how it is framed, a literal interpretation might create an absurd outcome. There is a little more about this in the premium section.

But if I had to nutshell it, I would do it this way: if your contract is a financial contract, involving the allocation of capital in return for investment income, you should expect to see gross-up arrangements claimed — even if you do not necessarily agree to them. But if your contract is for the provision of goods and services — if you are being paid against delivery or provision of something that will cost you money to put up, and the contract does not have a financing component — then there there is no need for a tax gross-up and you shouldn’t have one.

To nutshell the nutshell:

Gross-ups do not belong in commercial contracts.

Miscellany

“Set-off” vs. “withholding”

Note also that that gross-up boilerplate often mixes two quite distinct ideas: amounts that must be clipped off and reserved for 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. They are quite different things. One would never gross up a set-off: you would simply not apply the set off — if not applying it is allowed.

“Withholding” vs. “deduction”

Happy news, readers: we have a report from the front lines in the battle between substance and form. The JC asked no lesser a tax ninja than Dan Neidle — quietly, the JC is a bit of a fan — the following question:

In the statement, “X may make a deduction or withholding from any payment for or on account of any tax” is there any difference between “deducting” and “withholding”?

We are pleased to report Mr N replied:

I don’t think there’s a difference. Arguably it’s done for clarity, because people normally say “withholding tax” but technically there’s no such thing — it’s a deduction of income tax.

Which is good enough for me. So all of that “shall be entitled to make a deduction or withholding from any payment which it makes pursuant to this agreement for or on account of any Tax” can be scattered to the four winds. Henceforth the JC is going with:

X may deduct Tax from any payment it makes under this Agreement.

* Gross-up on dividends?

* Gross-up on bond coupons

* Gross-up in commercial contracts?

See also

* FATCA Amendment - ISDA Provision

* Gross-Up - ISDA Provision

* Deduction or Withholding for Tax in the ISDA Master Agreement

This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit jollycontrarian.substack.com/subscribe

This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit jollycontrarian.substack.com/subscribe