What Do Arm’s Length Transactions Mean?

Meaning

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 is two basis to arm’s length price:

  1. 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 exist is that it must be between unrelated persons. 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.
  2. 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-arms length transactions. In such transactions, buyers and sellers have an identity of interest and have an existing relationship, whether business-related or personal.

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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 an arms-length price which are mentioned below:

  1. Setting a Fair Price: The parties should try to reach and make the transaction at an 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 the market price which informed and unpressured buyers would pay to the seller on the basis of the property only.
  2. 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.
  3. Tax compliance: The tax laws state that all 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 deficiencies in compliance, these offenses are taken seriously and they may be subject to heavy penalties.
  4. To avoid conflict of interest: The purpose of dealing with transactions with an arm’s length price is to avoid a 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.

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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:

  1. Independent appraisal: While valuing property, it is customary to get an engineer’s 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.
  2. Independent negotiators: While going for the jugular prices, the expert as an attorney or broker shall be hired for the task of negotiating the prices and making sure all the laws in hand are being complied with.
  3. Get it in writing: Both parties should get everything to paper. There should not be a handshake or verbal contract. There should be no hidden clauses. All the terms and conditions must be put to the contract duly to be signed by attorneys where necessary.

Examples of Arm’s Length Transactions:

  1. Sales Transactions:
    • A sale between two unrelated companies at a fair market price, where the buyer and seller have no relationship with each other and act in their own self-interest.
  2. Leasing Transactions:
    • A lease agreement between two unrelated parties, where the terms and conditions of the lease are set at a fair market value and the lessor and lessee act in their own self-interest.
  3. Service Transactions:
    • A service agreement between two unrelated parties, where the terms and conditions of the service are set at a fair market value and the service provider and recipient act in their own self-interest.
  4. Loan Transactions:
    • A loan agreement between two unrelated parties, where the terms and conditions of the loan are set at a fair market value and the lender and borrower act in their own self-interest.
  5. Employment Transactions:
    • A transaction between two unrelated parties, where the status of one party (such as an employee, agent, or distributor) is set at a fair market value and both parties act in their own self-interest.
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It is important to note that arm’s length transactions are those that take place under normal market conditions and do not involve any type of special arrangement or relationship between the parties involved.

Examples of Not Arm’s Length Transactions:

  1. Related Party Transactions:
    • A transaction between two related parties, such as a parent company and its subsidiary, where the terms and conditions of the transaction may not reflect fair market value due to the relationship between the parties.
  2. Transactions with Conflicts of Interest:
    • A transaction between two parties where one party has a conflicting interest, such as an employee or director conducting a transaction with the company they work for, resulting in terms and conditions that may not reflect fair market value.
  3. Transactions with Hidden Benefits or Concessions:
    • A transaction between two parties where one party receives hidden benefits or concessions, such as a supplier offering a discount to a customer in exchange for a guarantee of future business, resulting in terms and conditions that may not reflect fair market value.
  4. Transactions with Unusual Terms or Conditions:
    • A transaction between two parties where the terms and conditions are unusual or outside the norm, such as a loan with a low-interest rate or an extended repayment period, resulting in terms and conditions that may not reflect fair market value.
  5. Transactions with Hidden Agendas:
    • A transaction between two parties where one party has a hidden agenda, such as a merger or acquisition with the intention of acquiring valuable assets, resulting in terms and conditions that may not reflect fair market value.

It is important to note that not arm’s length transactions may raise concerns about the fairness and transparency of the transaction and may require additional scrutiny or investigation to ensure that the terms and conditions of the transaction reflect fair market value.