Also known as grossing-up. Under a gross-up clause, a payor must pay an additional amount to a payee to ensure that the payee receives and retains the same amount that it would have received had no tax been withheld from, or otherwise due as a result of, the payment. Gross-up clauses are typically included in a wide variety of transactions documents, including credit agreements, deal documents, employment agreements, and swap documents.

For example, assume that the borrower in a loan agreement must pay $100 of interest to the lender but has to withhold tax at a 30% rate. In this case, the borrower will pay $70 to lender and $30 to the IRS. If the loan agreement includes a gross-up clause (which is customary), the borrower will have to pay the lender an additional sum so that the lender receives and retains $100. At first glance, that sum may seem to be $30. However, that $30 itself may be subject to withholding tax, in which case the borrower must pay $21 to the lender and $9 to the IRS. The borrower would then still be obliged to pay $9 to compensate the lender but again withholding might apply. If a withholding tax applies, the borrower must pay $6.30 to the lender and $2.70 to the IRS. This process continues until the lender receives and retains the same amount that it would have received had no tax been withheld from the payment ($100 in this example). This process is called grossing-up.

If the withholding tax rate is 30%, the gross-up formula to determine the aggregate amount to pay the payee is: (the dollar amount of interest owed x 100) ÷ 70. Therefore, in this example, the borrower must pay the lender $142.86 under the gross-up clause for every $100 of interest owed.