Arm’s Length Transaction – Definition, Types and; Example

Arm’s Length Transaction - Definition, Types & Example
Tally Solutions | Updated on: March 16, 2022

What is an arm’s length transaction?

Arm’s length transactions are also known as the arm’s length principle (ALP). It is a transaction between two parties in which both the parties are independent and are taking care of their self-interest. There is no connection between the parties that influences the bargaining power. Both the parties participate in the transaction only to achieve the deal that will be the most beneficial for themselves.

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 Fair market value in an arm’s length transaction

It is important to note that the parties act independently of each other. If we look at a sale transaction where the buyer and the seller do not know each other, they are only motivated to get the best deal for themselves. The buyer will want to settle for a price for the maximum profit, and the buyer would want a price that is as low as possible. So the seller would quote as high as possible while the buyer will make an offer as low as possible. The seller would use every advantage possible to highlight the value of the item being sold. The buyer would try to pick holes in the description to find reasons to lower the rate as much as possible. Since both the parties want the maximum benefit, the transaction value will ultimately be close to the fairest market value for the item being sold/bought.

Example of an arm’s length transaction

We can take an example of an arm’s length transaction as a person A who wants to sell his old car. An expert car dealer tells him that his car is worth around $21,000. He puts his car for sale on an online portal. A buyer who does not know him contacts him with an offer of $20,000. ‘A’ thinks that the price is fair. But, his friend who has lost his job also needs a car. He cannot afford to pay $20,000 and asks A if he could buy the car for $12,000. If A were to sell the car to the buyer who contacted him online he would be making an arm’s length transaction. It would not be so if he were to sell to his friend since he knows the person, and there would be a bias in determining the sale amount. He would be influenced by his affection for his friend and his sympathy for his difficult financial situation. His friend would benefit, but A would not care for his own self-interest in the transaction.

The importance of an arm’s length transaction

Public companies need to conduct all transactions at arm’s length. Shareholders want a company that they have put their money in to get the most advantageous deal every time. When there is a personal bias, there is always the possibility of malpractice or sacrificing the company's interest.

When a company avoids arm’s length transactions, the trust of the investors and shareholders gets eroded. Many companies have faced falling share values, protest from shareholders, investigations, and actions against the decision-makers due to not ensuring arm’s length transactions.

A person or company can transact with someone they know well without allowing the relationship to affect the fairness of the deal value. But arm’s length transactions prevent any suspicion or problems in investors' minds. To avoid allegations, businesses should go the extra mile to ensure that all transactions are arm’s length transactions.

When companies issue notices that call for interest or bids, they usually specify that family members and those related to shareholders are barred from participation. This is to ensure that there is fair play and the fairest price is arrived at in an arm’s length transaction. A deal in which there is a relationship between the parties or shared interest in the deal is called an arm-in-arm transaction or a non-arm’s length transaction. The relationship could be business-related or personal in nature.

Depending on the local laws and regulations, the difference between an arm’s length transaction and a non-arm’s length transaction may have legal and tax implications. Some countries would require that the tax for a transaction be determined based on the fair value if it were an arm’s length transaction rather than the lower amount that it is actually transacted at in a non-arm’s length transaction. The seller would have to factor this in when they transact at a lower price because of the relationship with the other party.

Many large companies and conglomerates have holdings in companies around the world. They may also have subsidiaries in various fields and locations. Instead of avoiding these companies when they do business, they follow strict business practices to ensure that there is no unfair bias for or against their subsidiaries. Ultimately, Arm’s Length Transactions support fair business practices and protect the public and investors.

Another way in which fair play is disregarded in companies is nepotism. Unfortunately, it is rather common to see that companies promote and nominate people to powerful positions overlooking the qualified candidates in favor of relatives and people known to them.

Using software for arm’s length transactions

We see that the ultimate purpose of arm’s length transactions is to keep personal or business connections from causing bias in any business transaction. Shareholders and investors have more confidence in a company that is very particular about arm’s length transactions as default in their dealings. Using software to maintain the accounts is essential for efficiency. An enterprise-level software such as TallyPrime that facilitates a strict and secure way of managing books also helps enforce accountability and compliance in the company. Arm’s length transaction is the basis of implementing honesty in a company’s dealings.

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