What is Arm’s Length Transaction?

Arm’s Length Transaction, also known as Arm’s Length principle, is a transaction between two unrelated parties without any potential for bias. Both parties have equal bargaining power and act in their own interests.

For example, Andrew wishes to sell his property for $550,000. He receives one offer of $500,000 from a stranger and another from his friend Sarah, at $400,000 owing to budget issues. If Andrew accepts the stranger’s proposal in an unbiased and uninfluenced manner, it would be an arm’s length transaction, obtaining a fair market value. However, if Andrew accepts Sarah’s offer, it would not be an arm’s length deal, as Andrew’s friendship with Sarah has influenced the bargaining dynamics between the two.

Key Highlights

Arm’s Length Transactions occur between two independent parties who bargain on an equal footing.
Parties involved in the transaction are unrelated and have no influence on each other.
Such transactions ensure that both parties value the assets at a fair price, provided that 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-arms length nature have implications on finance and taxation.

How Does an Arm’s Length Transaction Work?

Arm’s length transactions typically involve capital assets, such as buildings, machinery, real estate, and mergers and acquisitions. These transactions affect not only the parties directly involved in the deal but also other parties (such as lenders) and similar transactions in the market.

As the parties are unrelated and have access to the same information, they have equal bargaining power. The buyer would want to pay the lowest possible price, while the seller would seek the highest possible price.

Such transactions have implications for the parties involved, the banks that finance them, and local tax authorities.

Examples

#1. The Noranda-Glencore Deal

In January 2023, Noranda Income Fund finalized an agreement with Glencore Canada Corporation. Through a legal arrangement, Glencore Canada Corporation acquired all of Noranda’s current priority units for C$1.42 per unit, amounting to $53.2 million.

#2. The ST Dupont Incident

ST Dupont, a French luxury brand, had subsidiaries located in Hong Kong. After being audited by the national tax authority, it was found that ST Dupont sold its merchandise to its subsidiary in Hong Kong below the arm’s length level. While the manufacturer faced significant losses from 2003 to 2009, its subsidiary made substantial profits.

Stages

Step 1: Seller makes the product available in the market.

An arm’s length transaction begins when someone makes a product available for sale.
It can either be a tangible asset, such as a car or building, or an intangible asset, like software or a stake in the company.

Example: Andrew puts on notice that he wants to sell his house for $550,000.

Step-2: Seller engages with the buyers

After seeing the seller’s advert, buyers express willingness to purchase the product, and the seller then interacts with potential buyers.
In the real estate industry, buyers typically approach sellers to inquire about purchasing a property.
In the manufacturing industry, manufacturers often approach retailers to make their products available in retail stores.

Example: Sarah (Andrew’s friend) and a stranger reach out to Andrew to buy the house.

Step 3: Price Negotiation

The seller aims to crack the deal at the highest possible price, while the buyer aims for the lowest possible cost.
In an arm’s length transaction, both parties have equal bargaining power and decide in accordance with their self-interest.
Based on all of the information, both try to arrive at a mutually agreeable price.

Example: Sarah offers to pay $400,000, while the stranger offers $500,000.

Step 4: Transaction Completion

In the end, parties either finalize the transaction or at least one party decides to leave the deal, finding a better option elsewhere.
An arm’s length transaction grants the liberty of price negotiation to both parties, thereby aiming for the best possible price.

Example: Andrew confirms the deal with the stranger at $500,000, which is the closest to the fair market value and is acceptable for both parties.

Characteristics

The buyer and the seller are independent of each other and have equal grounds for bargaining.
Both parties do not influence each other’s interests and are free from any pressure.
As both parties act in accordance with their self-interests, the concluding price turns out to be the best market value of the asset, i.e., 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 parties to execute deals in their best interest and welfare.
The price that both parties determine is called the fair market value, which reflects various factors related to an asset, such as demand-supply trends, economic conditions, legal life, and the residual value of the asset.
Additionally, it also reflects financing factors such as interest rates and the tenure of the loan.
The fair market value represents the best possible price of an asset that is mutually agreed upon by both parties.

Example: Andrew’s house has a fair market value of $500,000, as he and the stranger negotiated equally, without any bias or influence, based on their self-interests.

Differences Between Arm’s Length Transactions and Non-Arm’s Length Transactions

Particulars	Arm’s length	Non- Arm’s Length
Parties to transaction	Not related to each other.	Related to each other.
Nature	Chances of influence on any of the parties are less.	Chances of influence on any of the parties are high.
Pricing	Fair market price	Unfair price
Tax revenue	Possibility of a loss of tax revenue to the states is negligible, as the transaction is taking place at a fair market value.	Possibility of loss of tax revenue is high when companies execute deals with related parties at unfair prices, resulting in incremental costs and diminishing their pre-tax profits.
Tax adjustment	No additional tax adjustment is required.	Party pays the taxes as per the calculated profits, based on post-transfer pricing adjustment.

Advantages and Disadvantages of Arm’s Length Transactions

Advantages	Disadvantages
A transaction between two unrelated parties is impartial and free from any compulsion, allowing for an accurate determination of the fair market value of the asset.	It typically takes longer to conclude an arm’s length transaction compared to non-arm’s length transactions.
The changes in lost revenue are minimal to tax authorities, which compels companies to adopt the arm’s length principle in transfer pricing.	Since arm’s length transactions are based on the FMV, the chances of deep discounts are lower as both parties act in their self-interest.

Final Thoughts

The transaction is considered to be at arm’s length when the involved parties act in their own self-interest. Pricing in such transactions is determined to be at fair market value, which is not influenced by personal factors. This concept plays a significant role in determining the tax liabilities of multinational corporations (MNCs), which treat both related and unrelated parties equally.

Frequently Asked Questions (FAQs)

Q1. What is an Arm’s Length transaction?

Answer: An arm’s length transaction occurs between two unrelated parties with equal bargaining power. Both parties are free of any bias or influences and conclude the deal at the fair market value of the asset.

Q2. What is a Non-Arm’s Length transaction?

Answer: A transaction that takes place between two related parties, where the deal is influenced by the personal interests of one of them. The concluding price can differ significantly from the fair market value, thereby resulting in profit for one party and loss for the other.

Q3. What is the Fair Market Value (FMV)?

Answer: Fair Market Value is the concluding price of an asset at which two unrelated parties conclude the deal. It results from an arm’s length transaction, where both parties are unbiased, uninfluenced, bargain equally, and behave according to their interests.

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