An arm’s-length transaction is a business deal, or transaction where the seller and buyer act independently of each other without influence on the other party. What sets these types of transactions apart is that there is no pressure from the other party and each party acts in their own self-interest. The arm’s-length transaction takes collusion out of the equation and regarding fairness, both parties have access to all the information connected to the deal.
Because arm’s-length transactions affect other parties besides the buyer and the seller, they are commonly used in real estate transactions. When two strangers become parties to a real estate transaction, the agreed-upon price is more likely to be close to the fair market value if they have the same bargaining power and information about the property. It’s logical that the seller would want the highest price possible, while the buyer wants the lowest price possible. If the two parties’ information and bargaining power are not the same, the agreed-upon price can either be higher or lower than the property’s fair market value.
But why does this matter? Well, a real estate transaction impacts the financing, taxation and other real estate transactions if the property is used as a comparable. If it’s an arm's-length transaction, the fair market value of the property is close to the agreed-upon price setting up a good basis for financing, real estate taxation as well as other properties that might use it as a comparable.
When it comes to transactions between family members or companies that share the same shareholders, arm's-length transactions are not a viable option. This is because those transactions involve entities that have a relationship, also referred to as an identity of interest. These types of transactions can result in deals that benefit one party, like when a father and son are involved in one. The father might be willing to give his son a discount. These transactions are known as non-arm’s-length transactions or arm-in-arm transactions.
It is essential to know about this difference because tax laws worldwide treat arm ’s-length transactions differently than when they aren’t. In the example given above, tax authorities can oblige the seller to pay taxes on the price the seller would have set for a neutral party. The same applies to international transactions to ensure that each country collects the correct taxes for the transaction.