One-sided contract term of the day (3): grossing-up of withholding tax

We continue our series highlighting IP Draughts’ “favourite” one-sided provisions in contracts.  These provisions are often found in contracts where there is an imbalance of power between the parties, and where the party with the power (let us call him the “Patron”) seeks to reduce a sometimes theoretical risk by imposing it on the other party (the “Supplicant”).

Today’s one-sided term is:

If any withholding tax is levied on the Payments, then Supplicant shall increase the sums paid to Patron so that the amount received by Patron after the withholding tax is deducted is the full amount Patron would have received if no withholding or deduction had been made.

This term differs from some of the others in the series in a number of ways.  First, it is focussed on an IP issue, or rather an IP tax issue – withholding tax.  Some of the other terms in the series could be found in many types of commercial agreement and are not specific to IP transactions.

Secondly, the presence or absence of the term doesn’t depend entirely on who has the bargaining power, although this has a part to play.  Instead, the use of such a term seems to reflect practice in particular industry sectors.  Thus, IP Draughts sees the term used frequently in software supply agreements, but very rarely sees it in biotech licence agreements.

What is withholding tax?

Many countries’ tax laws, including those in the UK, start from the assumption that where IP royalties are paid, tax should be deducted by the payer (ie the licensee) from the amount of the royalty, and paid to the tax authorities in the licensee’s country.  The net amount, less the tax, can then be paid to the licensor.  In some situations, reliefs and exemptions may be available that allow the payment to be made gross, ie without deduction of tax.

It is important to stress that what is being deducted is an advance payment of the licensor’s tax.  Typically, basic rate income or corporation tax (the name varies between jurisdictions) is deducted. Thus the licensee is acting as an unpaid tax collection agent for tax that has nothing to do with him.

While this tax system may be unfamiliar to many people, you may be more familiar (at least in the UK) with the fact that, on an interest-bearing bank account, your bank deducts basic rate income tax on interest payments, and sends you a certificate of tax deducted at the end of the year.  You include this certificate in your annual income tax submission and the tax authorities take it into account when calculating the tax due.  Essentially, the deduction at source of tax on interest is the same system as applies to royalty payments, and for that matter dividends on shares.

This withholding of tax at source is commonly known as withholding tax.

Deduction of tax on royalties at source can cause several problems for the licensor.  If he is not a taxpayer, or is not a taxpayer in the licensee’s country, it may be difficult for him to recover the tax, or (even if he can recover the tax) he may suffer a short-term cash flow disadvantage.  If he is a taxpayer in another country, he may find himself being taxed twice on the same income in two countries.  This is known as double taxation.

To mitigate the effect of double taxation, most countries of the world have entered into bi-lateral double tax treaties with most other countries of the world.  The terms of those treaties vary, but over time as they are periodically renewed, many are being redrafted to conform with an OECD model.  This is gradually removing some of the quirks of some of the treaties.  For example, while many treaties allow 100% relief from basic rate tax in the licensee’s territory if certain conditions are met, some of the treaties with Far Eastern countries have historically allowed only 50% relief.  During the 1990s, IP Draughts was involved in helping a UK biotech company that was prejudiced by the fact that the UK:Japan treaty only allowed 50% relief.  IP Draughts understands that the latest UK:Japan treaty allows 100% relief from withholding of tax.

Typically, to obtain the relief, the licensor must obtain evidence from the tax authorities in his home territory showing that he is a taxpayer in that territory.  That evidence is given to the licensee, who shows it to the tax authorities in the licensee’s territory and seeks permission to make the royalty payments gross, ie without deduction of tax.

Addressing the withholding tax risk

In biotech licence agreements (to take one of the examples given earlier), IP Draughts has typically seen wording such as the following:

The Payments shall be made without deduction of income tax or other taxes charges or duties that may be imposed, except insofar as the Licensee is required to deduct the same to comply with applicable laws.  The Parties shall cooperate and take all steps reasonably and lawfully available to them, at the expense of IP Owner, to avoid deducting such taxes and to obtain double taxation relief.  If the Licensee is required to make any such deduction it shall provide IP Owner with such certificates or other documents as it can reasonably obtain to enable IP Owner to obtain appropriate relief from double taxation of the payment in question.

The above wording provides that the parties will try to avoid withholding of tax, but ultimately if the licensee is required to deduct tax he may do so.  This is a tax issue for the licensor and ultimately, in the above wording, the risk is borne by the licensor.

The “one-sided” wording quoted at the beginning of this piece takes a different approach.  It requires the licensee to “gross up” the amount of the payment so that, after deduction of tax, it is the same amount as was originally agreed to be paid.  With this approach, the risk is passed to the licensee.

Who bears an individual risk in a contract is ultimately a matter for commercial negotiation, and the answer to this question may be affected by industry practice and the relative bargaining power of the parties.  In some cases, the risk may have been factored into the price.  It is for the parties  to decide what deal terms they want to agree, and IP Draughts claims no superior knowledge to tell them differently.

Standing back from market practice, though, it does seem strange to IP Draughts that a licensee should have to bear a risk that he cannot control, and where the nature of the risk may depend on the structure of the licensor organisation (eg whether he has a trading subsidiary in the licensee territory that can offset the tax against profits) and its current tax status.

IP Draughts’ scoring for extremeness: 6/10

2 Comments

Filed under Contract drafting, General Commercial

2 responses to “One-sided contract term of the day (3): grossing-up of withholding tax

  1. Vance Koven

    Quite true, but like Lewis Carroll’s ingenious argument in Achilles and the Tortoise about why you can never get from A to B, the observation only takes you…so far. A simple algorithm will yield a finite sum at any given rate of tax to the smallest relevant monetary denomination (in the US it’s all rounded to the nearest dollar).

  2. Christopher Whent

    In the quoted one-sided example, it seems to me that the party under the obligation to withhold can never satisfy the obligation. The sum to be remitted equal to the tax withheld is itself surely subject to withholding tax, which requires a further remittance, and so on ad infinitum.

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