The law defines arm's length transactions as those whose parties are independent and transact on an equal footing. This principle is used in contract law to arrange for equitable agreement even in a case where parties to a contract may be related (are relatives) in some way or have similar interests, such as employee-to-employee transactions. Arm's length markets also include transfer pricing between a parent company with its branches in other countries.

To determine whether a transaction is arm's length, the law checks if one of the parties had undue influence on the other party. If either of the parties signed the agreement under duress, then the transaction will not stand up to scrutiny. For example, a transaction in which a supervisor coerces a subordinate to sell him or her some property does not pass this test.

Secondly, if one of the parties lacks the capacity to transact, it gives the other party complete control. Thus, the transaction is not done on an equal footing. An example of this could be a parent transacting with a child who has not reached the age of 18.

Where the parties are closely related, the law checks if the good being sold is sold at the prevailing market value and that there is no misrepresentation of facts. For example, a person selling a house to a relative may be tempted to sell it below the market price. Such a transaction may be classified as a gift rather than an arm's length transaction.

The investing basics that one should practice in business transactions include appointing an independent third party where parties are closely related, selling at the appropriate price and checking whether both parties have the capacity to transact.

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