An arm’s length transaction refers to a business deal in which buyers and sellers act independently without one party influencing the other. These transactions ensure that both parties operate in their own self-interest and are free from undue pressure. They provide assurance to others that there is no collusion between the buyer and seller. For the sake of fairness, both parties generally have equal access to information relevant to the deal.
Key Takeaways
- An arm’s length transaction is a business deal involving parties who act independently.
- Both parties in an arm’s length sale usually have no prior relationship.
- These transactions in real estate help ensure properties are priced at fair market value.
- Arm’s length transactions impact financing and taxes.
- Deals between family members or related companies are not considered arm’s length transactions.
Understanding Arm’s Length Transactions
Arm’s length transactions are prevalent in real estate deals because they affect others beyond the involved parties, such as lenders. For instance, if two strangers are involved in the sale and purchase of a house, the final price they agree upon is likely close to the fair market value (FMV) given that both parties have equivalent bargaining power and access to information about the property.
The seller aims for a high price, while the buyer seeks a low price, making the agreed-upon price fair. This has direct ramifications on the financing needed from financial institutions as well as municipal and local taxes, and it also influences comparable prices in the market.
Arm’s Length vs. Non-Arm’s Length Transactions
Family members and companies with related shareholders generally engage in non-arm’s length transactions. In these arm-in-arm transactions, the buyers and sellers have a pre-existing relationship, either business-related or personal. For example, a father selling his house to his son at a lower price would be doing a non-arm’s length transaction because their relationship influences the transaction’s terms.
For tax purposes, if such a sale is taxable, tax authorities may require the seller to pay taxes on the potential gain as if the sale were to a neutral third party, disregarding the actual transaction price.
International sales between non-arm’s length companies, like subsidiaries of the same parent, must use arm’s length prices through transfer pricing practices to ensure proper taxation. Global tax laws differentiate between arm’s length versus non-arm’s length dealings, ensuring fair practices.
Arm’s Length Transactions and Fair Market Value (FMV)
One of the key benefits of arm’s length transactions is fairness, especially in real estate deals. When the buyer and seller lack a prior relationship, the deal’s conditions—especially the sale price—rightly reflect market conditions without undue influence, giving an accurate fair market value (FMV).
The FMV of a home is determined by several factors such as:
- Location (city, neighborhood)
- Comparable home prices
- Condition and age of the home
- Size and amenities
- Renovations and upgrades
Other influencing factors could include interest rates and the state of the overall economy.
Example of an Arm’s Length Transaction
Assume that John is selling his home and posits a market value of $350,000. An offer matching this FMV arrives from a potential buyer who considered all relevant value factors, like location and comparable sales. If the sale goes through, it establishes an arm’s length transaction.
Conversely, if John’s son, Henry, decides to buy the house at a significantly lower offer of $275,000 due to their relationship, it would be a non-arm’s length transaction.
What Is the Difference Between an Arm’s Length Transaction and Other Sales?
An arm’s length transaction occurs when buyers and sellers are independent of each other with no external affiliations affecting their decision. On the other hand, sales between parties with relations, like family members or related company entities, are non-arm’s length.
Why Are Arm’s Length Transactions Important?
The distinction impacts legal and tax implications. For instance, multinational firms must validate that international intra-company transactions meet fair market values to ensure correct cross-border taxation. Additionally, conglomerate entities might face legal challenges if related internal transactions aren’t at arm’s length. Overall, promoting arm’s length transactions supports fairness in business practices.
What Are Some Examples of Non-Arm’s Length Transactions?
An example is a mother selling a car to her son below its market value ringmarked for an arm’s length transaction, signifying non-arm’s length. While benign in this case, more complex scenarios could prove harmful, like a business founder showing nepotism that undermines the meritocracy within the company.
The Bottom Line
Achieving the best financial transaction outcome often relies on engaging in arm’s length transactions. This ensures that transactions are influenced purely by business logic rather than personal relationships, providing fair market value manifestations. Avoiding non-arm’s length transactions help maintain equitable market dynamics and coherent lending decisions.
Related Terms: Transaction, Fair Market Value, Financing, Transfer Pricing, Non-Arm’s Length Transaction, Collusion
References
- OECD. “Transfer Pricing Guidance on Financial Transactions”, Pages 31 - 34.
- Internal Revenue Service. “Allocation of Income and Deductions Under IRC 482”.
