The idea of an arm’s length transaction relates to an agreement between two people or entities that are independent of one another. This means that they do not have a prior relationship with one another, such as being related to each other, having a prior deal with each other, or that one party controls the other in some way. In certain situations, it is important to be able to prove that an agreement was entered into freely by both parties, to prove that the price, requirements, and conditions set within the transaction were fair and real at the time the transaction was made. To explore this concept, consider the following arm’s length definition.
Definition of Arm’s Length
- A situation in which the parties have no prior relationship with each other.
- Not closely or intimately related or associated; distant; remote
- In accordance with market values, disregarding any connection such as common interest in, or ownership of, the companies involved.
Arm’s Length Principle
The arm’s length principle is a condition in which the parties to a transaction have no prior relationship with each other, and that they are equal parties to the transaction. In consideration of the arm’s length principle, parties are considered independent of each other when they are not related to each other in the familial sense, nor have they engaged in any prior deals with each other, and have no side deals with each other. The arm’s length principle also helps guide transactions insofar as appropriate taxation is concerned.
An example of the arm’s length principle at work involves a supervisor’s use of the company’s human resources department to fire an employee. While the employer and the employee do have a prior relationship with each other, the termination itself is conducted by a neutral third party who is not a party to that relationship. This is done to protect the employer from any lawsuits that the employee may be able to bring upon being terminated, should he be terminated in a way that deviates from the labor laws within that jurisdiction. The arm’s length principle here ensures that the employer and the employee each have an unbiased and qualified advocate on his side.
Arm’s Length Transaction
Arm’s length transactions are transactions wherein the buyers and sellers to the transaction have no prior relationship with each other. Arm’s length transactions ensure that each party is acting in his own self-interest, and that neither party is being pressured by the other party to go ahead with the transaction. This also reassures any potential third parties to the transaction that no collusion exists between the buyer and the seller.
Arm’s length transactions must be conducted in real estate transactions to ensure that the price being offered for the property is consistent with the fair market value for that property. For instance, when two strangers are parties to a real estate transaction, the seller wants to charge the highest possible price for that property, and the buyer wants to pay the lowest possible price for that property. Therefore, it is more likely that the final agreed-upon price is at, or close to, fair market value.
However, in situations where the parties are not strangers, which are referred to as “non-arm’s length transactions,” it is less likely that the price offered and/or obtained for the property is close or equal to fair market value. For instance, a mother who is selling her house to her daughter is more likely to give her daughter a discount on the property, rather than charge her a price at or close to fair market value, which may be significantly higher.
Non-Arm’s Length Transaction
Non-arm’s length transactions are transactions that exist between people who already have an existing relationship. The relationship in a non-arm’s length transaction can be of a personal or professional nature, and it can exist between the buyer and the builder, the developer, or the seller. It may seem easier to purchase a house from a friend or a relative, but risks still exist within such a transaction.
For instance, the financial situation of the person selling the house in a non-arm’s length transaction can change. Because the seller knows the buyer will be sympathetic to his situation, he may end up asking the buyer for more money. This is especially true if the seller provided the buyer with a loan, as opposed to sending the buyer to a mortgage lender.
The taxation on a piece of property also significantly varies between a non-arm’s length transaction and an arm’s length transaction. For instance, using the example presented above, if a mother sells her house to her daughter at a discounted rate, tax authorities are within their right to force the mother to pay taxes on the gain she would have received if she had sold the house to a neutral third party, rather than her son.
The taxes are based on the fair market value of the property, not the discount that one party may choose to give to another. This then results in a loss that the seller is implying that he is willing to accept in giving the buyer a discount on the property.
Arm’s Length in Transfer Pricing
The arm’s length in transfer pricing principle states that the amount that is charged by one party to the other party in the transaction must be the same as if the parties were not related. For example, the arm’s length price must be the same as what the price would be on the open market.
When dealing in commodities, arm’s length in transfer pricing is rather straightforward, and can be as easy as researching comparable transactions. However, if the transaction deals with trademarked goods or services, then settling on an arm’s length price can be more complicated.
Parties engaged in arm’s length in transfer pricing transactions in the United States are guided by the best method rule when determining the appropriate arm’s length price for the transaction. The Best Method Rule requires that the method used to arrive at the best transfer price be the one that offers the best precision in matching the price of a comparable transaction. IRS regulations can guide parties insofar as helping them with determining the best possible method for their transaction.
Arm’s Length Example Involving a Foreclosure Sale
What follows is an example of an arm’s length transaction that was brought before the Ohio Supreme Court. In March of 2007, Craig Fennel, president of Fenco Development Company, filed a complaint on behalf of his company with the local Board of Revision (BOR) against an auditor’s valuation of an apartment building that Fenco had purchased the year before.
The auditor’s valuation came in at nearly $480,000. Fenco, however, claimed the property’s value was actually $135,000, which is the price that Fenco paid to the United States Department of Housing and Urban Development (HUD) when it purchased the building at a foreclosure auction.
The BOR held a hearing in September of that year, at which Fennel testified that the property had been vacant for two years, and provided photographic evidence that it was in run-down condition. He also testified that he was holding on to the property, waiting to improve on it until other properties had been improved first.
The auditor countered by submitting a report prepared by one of its staff appraisers that indicated that no one had made a sufficient claim or submitted the appropriate documentation to show that the valuation of the property should be reduced. The appraiser agreed that the condition of the property was “deplorable,” however she testified that the foreclosure sale “[did] not indicate a market sale.”
The BOR determined that the evidence proved that the run-down condition of the property had made it difficult to sell through auction, and that the final sale price had proved the true value of the property at the time that it was sold. The decision was appealed to the Board of Tax Appeals (BTA). The BTA ultimately determined that an arm’s length sale must be voluntary, and that the “public sale was carried out voluntarily by the seller.” Further, the BTA noted that the auction contained “the elements of an arm’s length transaction.”
Because the BTA ruled that the sale was an arm’s length transaction “upon which the BOR properly relied in valuing the property for tax year 2006,” the BTA affirmed that the sale price of $135,000 should be considered the true value of the property at the time it was sold.
The case was then appealed to the Ohio Supreme Court. The Court ultimately reversed the BTA’s ruling, holding that a foreclosure sale of real property does not qualify as an arm’s length transaction in an action whose sole purpose is to revalue the property before the BOR. The Court came to this conclusion by applying the logic that a foreclosure sale is motivated by the desire to satisfy one or more creditors. Therefore, this motivation could be considered a form of duress, which negates the independence expected from the parties to an arm’s length transaction.
The Court disagreed with the BTA’s finding that the HUD sale of the property could be considered “voluntary.” Instead, the evidence pointed to the fact that the HUD tried to sell the property to another bidder for $506,000, and when that deal fell through, the HUD accepted Fenco’s significantly lower bid. The Ohio Supreme Court’s ruling in this case was a landmark decision that will impact all future BOR cases going forward, which involve the selling of properties via foreclosure auctions.
Related Legal Terms and Issues
- Board of Revision – An organization that is comprised of a county’s auditor, treasurer, and president of the board of county commissioners or representatives.
- Collusion – A secret or illegal cooperation, especially organized for the purpose of cheating or deceiving another party.