What is Arm’s Length Transaction?
An Arm’s Length Transaction, also known as the Arm’s Length principle, is a transaction between two unrelated parties without any internal bias where both have equal bargaining power.
For example, Andrew wants to sell his property for $550,000. He receives one proposal from a stranger at $500,000, and another from Sarah, his friend, who is a bit low in budget, at $400,000. If Andrew accepts the stranger’s proposal, unbiased and uninfluenced, we consider it an Arm’s length transaction resulting in the fair market value of the transaction. If Andrew accepts Sarah’s offer, it is a non-arms-length deal because they are friends, influencing Andrew’s bargaining power.
- Arm-length Transactions are deals occurred between two independent parties who bargain equally.
- The parties involved in the transaction are non-related.
- Thus, they possess equal bargaining power without having any influence on each other.
- These transactions ensure that both parties value the assets at a fair price, provided the parties involved have an equal amount of information and act in their self-interest.
- Deals between family members, close relatives, friends, and companies with cross holdings are not arm’s length transactions.
- Transactions of a non-arm’s length nature have implications on finance and taxation.
How Does an Arm’s Length Transaction Work?
Arm-length transactions generally occur while dealing in capital assets, such as buildings, machinery, real estate, and mergers and acquisitions. Such transactions impact the parties directly involved in the deal and other parties, such as lenders and similar transactions, which are likely to take place in the market.
As the parties are unrelated and have the same amount of information available, it will reflect the equal bargaining power of the parties. The buyer would want the price to be as low as possible, and the seller would be willing to sell at a high price.
This transaction has implications for the involved parties, the banks who finance these transactions, and local tax authorities.
#1. The Noranda-Glencore Deal
Noranda Income Fund finalized an agreement with Glencore Canada Corporation in January 2023. A legal arrangement helped the latter obtain all the current priority units of Norada for C$1.42 per unit. The amount sums up to $53.2 million.
#2. The ST Dupont Incident
ST Dupont (a French luxury brand) had subsidiaries located in Hong Kong. After pricing by the national tax authority, the former sold its merchandise to the latter below the arm’s-length level. While the manufacturer faced significant losses (2003-2009), its subsidiary made substantial profits.
Step-1: Seller makes the Product Available in the Market
- Arm’s length transaction begins when someone makes a product available for sale.
- It can be a tangible asset like a car or building or an intangible asset like software or a stake in the company.
Example: Andrew puts on the notice that he wants to sell his house at $550,000.
Step-2: Seller Engages with the Buyer
- The buyers express their willingness to purchase the product through the seller’s post, after which the seller interacts with potential buyers.
- In real estate, buyers approach sellers to buy the property.
- In manufacturing, the manufacturers approach the retailers to make the products available in the retail store.
Example: Sarah (Andrew’s friend) and a stranger reach out to Andrew to buy the house.
Step-3: Price Negotiation
- At this stage, the seller wants to sell at the highest possible price, and the buyer intends to crack the deal at the lowest possible cost.
- Being the arm’s length transaction, the parties’ bargaining power is equal, so they aim to work toward their self-interest.
- Based on their information, both try to arrive at a price acceptable for both.
Example: Sarah, his friend, offered to pay $400,000, being a bit low on her budget, while the stranger came up to Andrew with an offer of $500,000.
Step-4: Transaction Concludes
- In the end, parties either finalize the transaction or at least one party decides to leave the deal, finding a better option elsewhere.
- While aiming at the best possible price, an arm’s length transaction provides freedom of price negotiation to both parties.
Example: Andrew confirmed the deal with the stranger at $500,000, which was nearest to the fair market value and acceptable for both of them.
- The buyer and the seller are independent and have the right to bargain equally.
- They do not influence each other’s interests and thus are free from pressure.
- Since both parties act according to their self-interests, the concluding price turns out to be the best market value of the asset, termed fair market value.
- The transaction is subject to taxation, and neither party profits unfairly from it.
- Two subsidiary parties under the same controlling head, located in two countries (having different tax rates), deviate from such transactions to avoid high taxation.
Fair Market Value in Arm’s Length Transaction
- In the absence of any personal relationship, arm’s length transactions allow the parties to execute a deal with their best possible interest and welfare.
- The price that both parties determine is called the fair market value.
- It reflects the following factors related to an asset: demand-supply trends, economic conditions, legal life, and the residual value of the assets.
- It also reflects financing factors like interest rates and the tenure of the loan.
- FMV is the best possible price of an asset that is mutually agreed upon by both parties.
- The buyer pays the amount to the seller and concludes the deal.
Example: The fair market value for Andrew’s house is $500,000, as he bargained with the stranger equally according to their self-interests without any bias and influence.
Transfer Pricing in Arm’s Length Transaction
- Transfer Pricing is a transaction between companies and their subsidiaries under the same controlling head.
- It is a non-arm-length transaction taking place according to the interests of one party (with a higher tax rate).
- It is how Multinational companies save their tax liabilities through a non-arm length transaction with their subsidiaries in other countries.
Differences between Arm’s Length Transactions and Non-Arm’s Length Transactions
Non- Arm’s Length
|Parties to transaction||Parties are not related to each other.||Parties are related to each other.|
|Nature||The chance of influence on any of the parties is less.||The possibility of influence on any of the parties is high.|
|Pricing||Fair market price||Unfair price|
|Tax revenue||The possibility of a loss of tax revenue to the states is negligible as the transaction is taking place at a fair market value.||The possibility of a loss of tax revenue is high, as companies would execute the deal at an unfair price with related parties resulting in incremental cost, thereby diminishing pretax profits.|
|Tax adjustment||No additional tax adjustment is required.||The party pays the taxes as per profits calculated based on post-transfer pricing adjustment.|
Advantages and Disadvantages of Arm’s Length Transactions
|The transaction between two unrelated parties is impartial, free from any compulsion, thereby arriving at the FMV of the asset.||It takes longer to conclude the deal than non-arm’s Length transactions.|
|The changes in lost revenue are minimal to tax authorities, and it compels the companies to adopt the Arm’s Length principle in transfer pricing.||Since the Arm’s Length transaction is subject to FMV, the chances of deep discounts are fewer as both parties act in their self-interest.|
The transaction is said to be at arm’s length when parties involved act in their self-interest. Pricing decided through these deals is considered fair market value, as this does not fluctuate due to personal factors. This concept plays a significant role while determining the tax liabilities of MNCs, which treat related and unrelated parties equally.
Frequently Asked Questions (FAQs)
Q1. What is an arm’s length transaction?
Answer: A transaction between two unrelated parties with equal bargaining power is called an arm’s length transaction. It is an unbiased and uninfluenced transaction where both parties conclude at the asset’s fair market value.
Q2. What is a non-arm-length transaction?
Answer: A transaction that takes place between two parties related to each other, influenced by the personal interest of any of them, is called a non-arm-length transaction. The concluding price differs significantly from the fair market value, resulting in a profit for one party and a loss for the other.
Q3. What is transfer pricing?
Answer: When a transaction takes place between two subsidiary organizations functioning under the same controlling head, it is called transfer pricing. The organizations generally belong to two different countries with different tax rates. A non-arm-length transaction takes place, and the company profits from the branch with a lower tax rate.
Q4. What is the fair market value (FMV)?
Answer: Fair Market Value or FMV is the concluding price of an asset at which two unrelated parties settle the deal. It results from an arm’s length transaction where both parties are unbiased, uninfluenced, bargain equally, and behave according to their interests.
This EDUCBA article is a guide to the concept of Arm-Length Transactions. For further study, please refer to EDUCBA’s recommended articles.