Meaning
Contractual allocations of potential tax liabilities that arise when a government imposes withholding taxes on cross-border payments protect the net income of the payee. This arrangement requires the payer to increase the nominal payment amount so that the net cash received after tax deductions equals the originally agreed price. When drafting international distribution agreements, a gross up clause tax risk arises if the payer cannot absorb the additional financial burden or fails to claim offsetting foreign tax credits.
Financial Burden
If a local authority imposes a high withholding tax, the payer must pay a larger total sum than anticipated.
Treaty Relief
Double taxation treaties can mitigate this problem by reducing or eliminating the withholding tax rate. To benefit from this relief, the paying party must navigate complex bureaucratic filings to prove the tax residency of the payee.
Negotiation Leverage
The distribution of this financial risk depends on the market power of the parties during contract negotiations. Strong brands can insist on absolute protection through these clauses, shifting the entire administrative and financial burden to the local distributor. Conversely, a distributor with a dominant market position may reject the clause, forcing the foreign supplier to accept lower net returns after taxes.
