What Is an Arm’s Length Transaction? Its Importance, With Examples
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What Is an Arm’s Length Transaction?
An arm’s length transaction refers to a business deal in which buyers and sellers act independently without one party influencing the other. Arm’s length transactions assert that both parties act in their own self-interest and are not subject to pressure from the other party. They also assure others that there is no collusion between the buyer and seller. In the interest of fairness, both parties usually have equal access to information related to the deal.
Key Takeaways
- An arm’s length transaction is a business deal that involves parties who act independently of one another.
- Both parties involved in an arm’s length sale usually have no relationship with each other.
- These types of deals in real estate help ensure that properties are priced at their fair market value.
- Arm’s length transactions can have an effect on financing and taxes.
- 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 affects not only those who are 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, the final agreed-upon price is likely close to fair market value (FMV), assuming that both parties have equal bargaining power and the same 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 not likely to differ from the property’s actual FMV.
As noted above, the buyer and seller aren’t the only ones involved in an arm’s length transaction. This type of transaction also has a direct impact on the financing needed from a bank as well as municipal and local taxes. The transaction can also influence comparable prices in the market.
Arm’s Length vs. Non-Arm’s Length Transactions
Family members and companies with related shareholders generally don’t engage in arm’s length sales. Instead, the deals between them are non-arm’s length transactions. This type of transaction, which is also known as an arm-in-arm transaction, refers to a business deal in which buyers and sellers have an identity of interest. Put simply, buyers and sellers have an existing relationship that is either business-related or personal.
An existing relationship tends to influence the terms of a non-arm’s length transaction. For instance, 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.
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.
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.
Arm’s Length Transactions and Fair Market Value (FMV)
As noted above, one of the main benefits of arm’s length transactions is that the transaction is fair and equitable. This is especially true when it comes to real estate deals. When the buyer and seller have no previous relationship, the terms of the deal—notably, the sale price—accurately reflect market conditions rather than being influenced by other factors. This value is referred to as the fair market value.
FMV is the best possible price that a neutral and impartial seller and buyer are willing to accept and pay to close the deal. The following are just some of the factors that are used to determine the FMV of a home:
- Location (city, neighborhood)
- Comparable home prices
- Condition and age of home
- Size and amenities
- Renovations and upgrades made to the property
Of course, other factors also work into the FMV of a home, including interest rates and the condition of the overall economy.
Example of an Arm’s Length Transaction
Let’s use a hypothetical example to show how arm’s length transactions work. We can start by expanding on the example above using the father and son and the real estate transaction. For clarity’s sake, let’s say the father’s name is John and the son’s name is Henry.
Assume that John is selling his home and puts the house up for sale for $350,000. He gets an offer for that amount based on the FMV. The potential buyer looked at some of the factors affecting the value, including the location, amenities, and comparable homes. If the sale goes through, it’s considered a arm’s length transaction.
But Henry throws John a loop saying he needs a new place and would like to buy the home for himself. He offers a lower price of $275,000 since it’s his father who’s selling the house. If John decides to accept, he would be conducting a non-arm’s length transaction.
What Is the Difference Between an Arm’s Length Transaction and Other Sales?
The term “Arm’s Length Transaction” refers to transactions that are conducted between parties who are acting independently from one another and are not associated with one another outside of the transaction in question. By contrast, a transaction would not be “arm’s length” if the buyer and seller are personally related—such as being family members or personal friends. Transactions between related businesses, such as those made between a parent company and its subsidiary, would also not be arm’s length.
Why Are Arm’s Length Transactions Important?
The question of whether or not a transaction is arm’s length matters because it can have legal and tax implications. For example, when a multinational corporation engages in transactions with its affiliated companies throughout the world, it must ensure that those transactions are made at fair market values to ensure that the correct taxes are paid in each jurisdiction.
Similarly, conglomerates and holding companies can potentially run into legal and regulatory challenges if the companies within their organization do not transact with one another at arm’s length. Ultimately, Arm’s Length Transactions are intended to encourage fair and reasonable business practices and to protect the public at large.
What Are Some Examples of Non-Arm’s Length Transactions?
To illustrate, consider the case of a mother who wishes to sell her car to her son. She might choose to give her son a discount on the car, even though she could obtain a higher price if she sold it to an arms-length buyer. In this scenario, the transaction is not arm’s length, because the buyer and seller are already associated as family members.
Although this example is benign, other examples could be more harmful. For instance, if the founder of a publicly traded company engages in nepotism by appointing one of their family members to an important position within the company, even though other more qualified candidates were available, this decision could harm the company’s shareholders.
The Bottom Line
Every buyer and seller wants to get the best price possible for their financial transactions. One of the best ways to do so is to conduct an arm’s length transaction. Being at arm’s length means there are no personal factors that influence the price and the decision to either accept or reject an offer. Those who execute non-arm’s length transactions may not get the best price, which can also affect the overall market and lending decisions.
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