What is an Arm's Length Transaction?
An arm's length transaction is one in which the buyers and sellers of a product 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. It also assures third parties that there is no collusion between the buyer and seller.
Arm's Length Transaction
Breaking Down Arm's Length Transaction
An arm's length transaction is more common in the real estate market and when dealing with tax authorities. In general, family members and companies with related shareholders are said to not be transacting at arm's length.
Arm's Length Transactions and Real Estate
Arm's length transactions help determine the fair market value of a piece of property. To properly set fair market value, the price for the property must be obtained through a potential buyer and seller operating through an arm's length transaction. Otherwise, the agreed-upon price is likely to differ from the actual fair market value of the property.
For example, 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 market value, assuming that both parties have equal bargaining power and equal information about the situation. The seller would want a price that is as high as possible, and the buyer would want a price that is as low as possible.
This contrasts with a situation in which the two parties are not strangers. For example, it is unlikely that the same transaction involving a father and his son would yield the same result, because the father may choose to give his son a discount.
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, stamp duty, or other municipal or local taxes, as well as the use of the transaction to set comparable prices in the market.
Arm's Length Transactions and Taxation
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. Using the same example as above, if the sale of the house between father and son is taxable, tax authorities may well force the seller to pay taxes on the gain he would have realized had he been selling to a neutral third party and 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.