Understanding tax change calls

There are two sides to every bond issuance. For investors, bonds are generally viewed as income-generating investments that provide regular interest payments and the return of principal at maturity.  

For issuers, however, bonds represent borrowed money. Like any loan, a bond carries an ongoing cost in the form of periodic interest payments and an obligation to repay the principal when the bond matures. At the outset, the arrangement is straightforward: investors earn income, while issuers obtain funding.

Once a bond is in the market, it is generally understood that market conditions will evolve over time. Interest rates may rise or fall, credit spreads may widen or tighten, and the bond's market value may fluctuate accordingly. These are normal risks associated with investing and borrowing.

But what happens when the tax rules change before the bond matures? 
 

Tax changes and the “gross-up” provision

Unlike market movements, tax changes are imposed by governments and can materially alter the economics of the original investor-issuer agreement. In some cases, they can increase an issuer’s borrowing costs in ways that were never considered when the bond was issued.

One key reason is the presence of a gross-up provision, a feature commonly found in international bond documentation. It states that if an applicable tax change reduces the amount an investor would otherwise receive, the issuer may be required to make additional payments to keep the investor whole.

Here’s an actual example of a gross-up provision, taken from the Republic of the Philippines’ ROP 34NEW and ROP 49 bond prospectus:

“The Republic will make all payments of principal and interest in respect of the global bonds free and clear of, and without withholding or deducting, any present or future taxes of any nature imposed by or within the Republic, unless required by law. In that event, the Republic will pay additional amounts so that the holders of the global bonds receive the amounts that would have been received by them had no withholding or deduction been required, subject to certain exceptions.” Source: https://www.sec.gov/Archives

While this protection benefits investors by keeping their coupons intact, it also shifts the cost to the issuer, who shoulders the additional tax burden. Tax change calls are designed to address this risk.

Put simply: The gross-up protects the investor. The tax change call protects the issuer. 

What is a tax change call? 
 

A tax change call gives the issuer the right, but not the obligation, to redeem the bond before maturity if a change in tax laws creates additional costs for the issuer.

Examples of trigger events:

• Introduction of a new withholding tax
• Changes to existing tax laws
• Changes in the interpretation or administration of tax regulations
• Any tax event that causes the issuer to pay additional amounts to investors
  
   

Anatomy of a tax change call
 

A typical tax change call is built around five key elements:

1. A qualifying tax event that affects a bond issuance and triggers the provision
2. An increase in the issuer’s costs arising from that event
3. The issuer's option (not obligation) to redeem the bonds, rather than continuing to bear the additional costs
4. Advance notice to investors before the call is exercised
5. A specified redemption price, usually at par plus accrued interest

Together, these provisions clearly establish when the call may be exercised and how the redemption process would take place.
 

What about the investor?
 

For investors, a tax change call generally means receiving their principal back earlier than expected, usually at par plus accrued interest. While this provides clear repayment terms, it may also require investors to find a new investment outlet, subject to prevailing market conditions at the time of early redemption. 

Tax change calls are generally regarded as low-probability provisions because changes in tax regulation are rare. Beyond the lengthy legislation processes, a number of conditions typically must be satisfied before an issuer can invoke the provision. Nonetheless, the risk is not zero, and the effect may be substantial.

For this reason, many bond issuers seek the protection of a tax change call option, which provides a safeguard against an unexpected and unavoidable increase in the cost of maintaining the debt. In that sense, the provision serves as an insurance policy: rarely needed, but valuable in case of unexpected and burdensome tax developments.

DANIEL ANDREW TAN is an Investment Counselor at Metrobank’s Markets Advisory Division. He leverages his extensive background in retail banking and wealth management to deliver strategic investment advice and bespoke portfolio solutions to clients and stakeholders. He focuses on delivering timely and relevant advice to help navigate shifting financial landscapes with confidence. Outside of work, he stays up-to-date on economic and political developments via podcasts and other alternative media.