Arm’s Length transactions are those business deals where both the parties to transactions i.e. buyers and sellers act independently without one party influencing the other. Such transactions depict that both the parties to the transactions have accorded in their own interest and without any undue influence from the other party.
It also implies that there exists no collusion between the buyer and seller. In the interest of fairness, both parties to transactions have equal access to information which are related to the deal.
Basis of Arm’s length price
There are two basis to arm’s length price:
- The parties must be unrelated: The buyers and sellers should not be related by any means. To test relations, the direct descendant of family members is considered to be related. For the companies, associates and subsidiaries are considered related. For directors, their family members are considered related. The only relationship for arm’s length transactions to existing is that it must be between unrelated persons. The unrelated persons act in their own personal interests. The supplier’s bargaining power is also vigorously tested and buyers also want the lowest possible prices and both leverage their strengths. Even when there are discounts, both buyers and sellers do come to a concluding price where the price is favorable to both.
- No pressure or duress involved: The transaction shall exist out of the willingness of buyers and sellers. This would mean that there is no coercion at work. If coercion is not in existence, the prices are fair. The party which coerces price gets benefited at the expense of another party.
Arm’s Length vs. Non-Arm’s Length Transactions
Generally, in a company, family members and related companies do not deal with arm’s length prices rendering them non-arm’s length transactions. In such transactions, buyers and sellers have an identity of interest and have an existing relation, whether business-related or personal.
For example, a transaction between father and son would not yield the same transaction price as a deal between strangers because the father would like to provide a discount to his son.
Why Having an Arms-Length Transaction is Important?
There are various reasons to have arms-length price which are mentioned below:
- Setting a Fair Price: The parties should try to reach and make the transaction at arm’s length price. It is generally based on the fair market value of the asset or if the direct asset is not available related assets. The fair price of property equates to market price which informed and unpressured buyer would pay to seller on the basis of the property only.
- Buying or selling a business: If anyone wants to purchase or sell the business, a fair price must be ascertained. On rare occasions, a guarantee is taken that the transaction has been conducted at arm’s length prices. If the warranty is not correct, the other party is subject to damages.
- Tax compliance: The tax laws state that all the business transactions shall comply with tax laws. The arm’s length transaction between related companies may result in the prices being high or low which will impact the taxable income for either party. If the revenue department audits and finds the deficiencies in compliances, these offenses are taken seriously and they may be subject to heavy penalties.
- To avoid conflict of interest: The purpose of dealing transaction with arm’s length price is to avoid complete conflict of interest. If the conflict of interest is discovered, the shareholders’ may object to the contract and result in avoidance of the contract, the terms of which are generally mentioned in each of the contracts.
How to Make Sure You Have an Arm’s-Length Transaction?
Things can get ugly and the contract can be void if the terms mention that transactions are made at arm’s length price while in reality, it is not.
The transaction would come under the scrutiny of the revenue department. Hence, the following points shall be considered to make sure that transactions are at arm’s length prices:
- Independent appraisal: While valuing property, it is customary to get engineers’ valuation report or get the property appraised by the real estate agent. If the business is being bought or sold, it is better to get a business valuation report.
- Independent negotiators: While going for the jugular prices, the expert as attorney or broker shall be hired for the task of negotiating the prices and making sure all the laws in hands are being complied with.
- Get it in writing: Both parties should get everything to paper. There should not be a handshake or verbal contracts. There should be no hidden clauses. All the terms and conditions must be put to contract duly to be signed by attorneys where necessary.