What Is an Arm's Length Transaction?
An arm's length transaction is a business deal in which the buyers and sellers act independently and do not have any relationship to each other. The concept of an arm's length transaction assures that both parties in the deal are acting in their own self-interest and are not subject to any pressure or duress from the other party. Both parties usually have equal access to information related to the deal. It also assures third parties that there is no collusion between the buyer and seller.
- The parties involved in an arm's length transaction usually have no pre-existing relationship with each other.
- These types of deals in real estate help ensure that properties are priced at their fair market value.
- Deals between family members or companies with related shareholders are not considered arm's length transactions.
Understanding Arm's Length Transactions
Arm's length transactions are commonly used in real estate deals because the sale effects not only those directly involved in the deal but other parties as well, including lenders.
If two strangers are involved in the sale and purchase of a house, it is likely that the final agreed-upon price is close to fair market value, assuming that both parties have equal bargaining power and equal information about the property. The seller would want a price that's as high as possible, and the buyer would want a price that is as low as possible. Otherwise, the agreed-upon price is likely to differ from the actual fair market value of the property.
Whether the parties are dealing at arm's length in a real estate transaction has a direct impact on financing by a bank of the transaction and municipal or local taxes, as well as the influence the transaction could have on setting comparable prices in the market.
Arm's Length vs. Arm-in-Arm Transactions
In general, family members and companies with related shareholders are not considered to be transacting at arm's length. These types of deals are also known as arm-in-arm transactions.
For example, it's unlikely that a transaction involving a father and his son would yield the same result as a deal between strangers, because the father may choose to give his son a discount.
Tax laws throughout the world are designed to treat the results of a transaction differently when parties are dealing at arm's length and when they are not.
For example, if the sale of a house between father and son is taxable, tax authorities may require the seller to pay taxes on the gain he would have realized had he been selling to a neutral third party. They would disregard the actual price paid by the son.
In the same way, international sales between non-arm's-length companies, such as two subsidiaries of the same parent company, must be made using arm's length prices. This practice, known as transfer pricing, assures that each country collects the appropriate taxes on the transactions.