Meaning
Base erosion rules monitor the reallocation of income from one national jurisdiction to another through transfer pricing or contractual arrangements. Multinational groups use cross border revenue diversion to centralize profits in locations with lower tax rates or favorable treaties. This practice is under increasing scrutiny by tax authorities worldwide to prevent the loss of domestic revenue.
Transfer Pricing
Setting the price for goods or services sold between related companies is the primary method of moving income. The cross border revenue diversion must be justified by the arm’s length principle to be accepted by the regulators. This means the price should be the same as what would be charged to an independent third party.
Treaty Application
Bilateral agreements between nations define which country has the right to tax specific types of income. The cross border revenue diversion often utilizes these treaties to reduce the withholding on dividends, interest, or royalties. Tax authorities look for the commercial purpose of the structure to ensure it is not used solely for tax avoidance.
This check prevents the use of shell companies in tax havens. The substance of the operations in each country must match the income reported there.
Enforcement Action
Penalties and back taxes are assessed when a company is found to have shifted profits improperly. The cross border revenue diversion can lead to double taxation if two countries both claim the right to tax the same income. This risk drives companies to seek advance pricing agreements with the government.
