What’s an Arm’s Length Transaction
In business, many transactions take place every day. As a business owner, the transactions you undertake are always meant to benefit you.
If you operate a retail chain, you will have to engage and buy goods from various suppliers.
Both you and them will have different terms which need to be acceptable to each other for the business deal to take place.
Your business terms may include the freshness and quality of the products supplied. They may also mention things like returns, discounts, quantities, deliveries etc.
Your supplier’s terms may talk about your credit period, returns, food storage in your outlets etc.
The important things considered by both you and him will form part of the agreement.
Why is it so?
Because everyone is looking out for his best interests.
You want to ensure you get the best deal out of transacting with every supplier. Your supplier on the other hand wants to ensure he gets the best deal out of you as his customer.
Transactions based on this kind of a situation are the ones referred to as arm’s length transactions.
Therefore, an arm’s length transaction is one in which the transacting parties are unrelated and are working for their own best interests.
This however does not mean that you stop thinking of the other party.
As a business, your intention should always be to take care of your customers’ interests.
And in an arm’s length transaction, you do this while ensuring your business does not suffer.
FACTORS DETERMINING AN ARM’S LENGTH TRANSACTION
Arm’s length transaction are the most common in business setups. But for a transaction to be classified as such, there are two elements which have to be in place. These are:
1. The parties must be unrelated – since business transactions take different forms, an arm’s length transaction is defined primarily by the kind of relationship between the parties involved.
Basically, the only relationship that stands to guarantee such a transaction is one between unrelated persons.
Being unrelated provides the perfect environment to ensure everyone acts in their personal interests. For example, a buyer’s bargaining power wants the lowest prices possible. You will pursue this through leveraging whatever strengths you have.
On the other hand, a supplier’s bargaining power wants the highest price for his goods. Also, he would prefer that you paid him immediately he delivers. This ensures his cash flow is good in order to facilitate business operations and growth.
Even if there are discounts being discussed, the final agreement will certainly be favorable to both you and the supplier.
As the supplier thinks about his cash flow, you will also be protecting your own.
2. There should be no pressure or duress involved – a business transaction should ideally be done out of willingness. This is the philosophy of willing buyer, willing seller which is expected and accepted everywhere. In the absence of willingness, there is coercion at work.
Whenever there is coercion involved in a business transaction, the prices are never fair. And if the prices are fair, then something else is wrong.
It could be the quality of work or any other aspect of the transaction. The one coercing will benefit at the direct expense of the other.
In some instances, this kind of transaction can also be labeled criminal depending on the kind of damages suffered. The transaction agreement can also be canceled under law.
Arm’s Length in the Real Estate
The arm’s length philosophy can be applied in every business transaction.
The real estate industry is however the one which often sees this at work, especially in regards to public knowledge.
This may be because the real estate sector often comes under scrutiny when home sales are done.
Every agent wants to sell at the highest price while every buyer, or his negotiator, wants the lowest price. Since there are many other parties who will be involved behind the scenes, care must be taken to ensure the deal is an arm’s length.
In a home sale, apart from the actual buyer and seller, other parties involved include the lender and the local government. The lender wants to be sure that the mortgage is the right value and has been given to a legitimate customer.
Local governments want to ensure that the price is right for the purposes of tax collection.
The lender is also interested in the deal as he will be filing for taxes based on the amount given.
In the unfortunate event that the transaction proves to have been a fraud, the lender will be counting losses.
ARM’S LENGTH VS. ARM-IN-ARM TRANSACTIONS
As you would expect, not all business transactions are arm’s length.
Even if these are the type preferred, some transactions simply cannot be arm’s length.
Such are those between relatives. It could be a transaction between a father and son, aunt and nephew, grandpa and daughter etc.
A transaction of this kind is called arm-in-arm.
This is symbolic of the close relationship between the parties involved.
In essence, an arm-in-arm transaction is nothing but the opposite of an arm’s length transaction. Whereas an arm’s length transaction works with unrelated parties, an arm-in-arm transaction happens between related parties.
This means that the scales will likely be tipped in favor of one party. This however, in most cases, will not be out of criminal intent.
The love in the relationship will make this transaction more of a case of giving out of goodwill.
Tax Considerations in Arm-in-Arm Transactions
Whenever money changes hands, there is bound to be a tax obligation.
Since both parties involved in an arm’s length will be paying taxes, it is important to ensure the transaction paints the correct picture of the nature of the deal.
In some cases, arm-in-arm deals may be attempted to be passed as arm’s length transactions.
This may be taken to be criminal by the authorities. In an arm-in-arm deal, you may be required to pay taxes of an amount similar to what you would have made had you transacted with a stranger.
To avoid penalties from the IRS, you will have to put in efforts to guarantee an arm’s length transaction.
How do you avoid these issues in a family transaction?
This is discussed further down in the article. Read about it in the section about arm’s length transactions in a family business.
Business Deals Between Subsidiaries
The tax situation in different business entities differ. The normal buyer/seller situation may not necessarily be realistic in subsidiaries.
This is because they all have a similar interest: the growth of the conglomerate.
What happens when a subsidiary wants to do business with another subsidiary in the same conglomerate?
This is the kind of situation family members find themselves in.
As much as the individual companies are interested in the best outcome for the other party, they cannot afford to transact in methods contrary to arm’s length.
This becomes more necessary when the companies are operating in different countries. This is a common situation in conglomerates as they are often multi-national.
But it is not just the business that is involved in cross-country business relations. The country of operation is involved too.
The tax agencies in those countries have to collect tax on the business dealings entered into by the companies operating within their jurisdictions.
This is why implementing an arm’s length policy between subsidiaries is important.
Without it, the companies may be accused of using tactics meant to facilitate tax evasion.
This can be a very costly problem for the company to deal with. If such allegations are confirmed, huge penalties will follow.
The business might even be required to shut down.
LENDERS AND ARM’S LENGTH TRANSACTIONS
As noted, the real estate sector is the one which receives most attention when it comes to arm’s length transactions.
As we have seen, a home purchase rarely involves only the seller and buyer.
Of the involved parties, one stands to lose a lot if the transaction is not an arm’s length. This party is the lender.
When banks issue mortgages, they expect the recipients to swear nothing but the truth. This helps them make the right decision in terms of the amount of money to be given, the terms and the taxes payable.
Banks have been the victims of fraud in many instances as people collude to make away with lots of money at the bank’s expense.
To prevent this, banks put in measures to safeguard themselves. There are two main benefits for the bank when the deal is an arm’s length.
1. Lower fraud risk caused by collusion – there have been reported instances of bank fraud when employees collude with people on the outside to commit crime. These crimes range from robbery of customers when leaving the bank after a big withdrawal to credit card fraud.
Where fraud exists, money is lost. When money is lost, profits reduce. And when profits reduce too much, losses may follow. If losses are experienced, investor confidence wanes.
No business will wants this as part of their story.
In the real estate scenario, a collusion may happen between a bank employee and an agent purporting to sell a home.
The agent may overvalue the property and advise the potential buyer to take the mortgage plan available from bank X.
The mortgage officer will approve the application and once the seller has the payment, he disappears. The buyer has no home to move into and the one who received the payment is nowhere to be found.
Upon doing an independent probe into the agreement, the bank finds out that the indicated location cannot even have a home of the value stated.
But because the buyer wasn’t knowledgeable enough, he got duped. And because there was collusion, the bank also suffered.
2. Increased transparency – arm’s length transactions are characterized by transparency. Since no-one is trying to hide anything as it often happens in arm-in-arm transaction, the bank can easily determine the amount of money to provide as a loan.
This is good for the bank as it provides them with security for their business.
Banks need to be sure of who they are dealing with. When there is more transparency, the bank is also assured of their projected earnings. They know that out of the money lent, they will be making a profit.
In transactions between relatives, banks will typically be more keen to ensure all is well.
Another important role played by increased transparency is protection against money laundering. In the money laundering world, criminals seek to transact through banks so as to “clean up” the money.
When the industry regulator finds out that a certain bank has been used in such a way, the bank will have some questions to answer.
More than that, news about a bank’s involvement in money laundering paints the bank in bad light.
Determining Fair Market Value
Transactions labeled arm’s length have one characteristic: they aim at sealing the deal based on the fair market value of the product being sold.
How do you know whether your transaction is in line with the fair market value?
Fair market value is determined by the process the transacting parties go through. Assuming that a factor like bargaining power are constant, then the fair market value is simply the amount agreed upon.
Another big assumption here is that both parties are able to carry out their own research to find out the prevailing value of the product being sold. If it’s a house, the buyer will not just rely on the information given by the seller.
He will check the house out, ask as many questions as possible then do his own personal research.
The personal research may include things like visiting the neighborhood to find out home prices.
It may also include checking with an independent valuer to know the average price to be paid for the home.
If these factors stand uncompromised, then automatically, the price agreed upon by the seller and buyer will be a true fair market value.
ARM’S LENGTH IN FAMILY BUSINESS
Family businesses are unique in many ways. Some of the challenges facing them are also unique.
This is why not many manage to break through and make it as big as other businesses.
Still, there are a few family businesses which have succeeded and become big.
When it comes to transacting between family-owned businesses, e.g. one owned by parents and another owned by the children, it takes more effort to guarantee an arm’s length environment.
The same applies to transactions which may not necessarily be about business.
For example, your dad could offer to sell you his car. Keep in mind that there are taxes involved and the best thing would be to avoid unnecessary scrutiny from the IRS.
To stay on top of things, the below are the steps to take.
Get an Independent Appraisal of the Property/Product
Your dad could tell you that his car’s value is $8,000. Whether true or not, an arm’s length transaction can only be proven by having an independent person carrying out the appraisal.
The appraisal will provide all the information needed for the transaction.
With an independent appraisal, there is still a challenge to be overcome. This is the challenge of sticking with the appraisal.
A common problem which occurs in family transactions is the tendency to put the appraisal aside and proceed in their own terms.
When getting an independent assessment of the car to be purchased, you are safeguarding yourself. An outsider doing the assessment will be objective and fair, not leaning towards either side.
If ever called upon to shine light in the situation, you would be able to prove that the value stated was determined by an independent expert.
In getting an independent appraisal, ensure you stick to it.
Hire Independent Negotiators
Getting an independent appraisal is not the only things to be done. You should also hire negotiators and give them all the necessary information they may need so as to push for the best deal.
In the example of your dad’s car, he should get a negotiator as you do the same. These negotiators are the ones to carry out the sale if they both agree with the terms set forth.
If you two are to be in the presence of the negotiators, it would be good to keep silent and only listen.
You can add a comment as the negotiations take place but do not engage with your dad on the sides about the deal which is yet to be finalized.
Have the Purchase/Sale Agreement in Writing
After all the work involved in ensuring you perform an arm’s length transaction, keep the records of the deal in writing. Do not make decisions using verbal agreements. Keep all the receipts, delivery notes, appraisal and any other related document. Both parties should have their own copies of these.
Having everything in writing indicates truth and finality. This is why most businesses will never engage without some form of documentation.
One simple but powerful enough form of documentation is emails. If you have had some business communication via email, ensure these are preserved.
In today’s technology-driven world, you could also back them up in the cloud and only access them if needed.
Provide Independent Verification that the Transaction is Arm’s Length
It can be a good idea to have a witness to the transaction who will attest to the fact that the transaction was arm’s length.
This witness may be what you will need to prove to the authorities that the transaction was above board.
When doing this, make sure you choose the right person for the role.
A transaction witness should never be your relative. A relative cannot be a trusted witness since he is inclined to speak in favor of the transaction.
Write an Affidavit
The last thing you can consider doing is writing an affidavit.
An affidavit is a document written to swear the truth about something. It is often written and commissioned by an attorney.
This may cost you some money depending on how much the attorney will charge.
The cost aside, an affidavit is a document which can be admitted in a court of law. Just note that you should never lie in an affidavit.
Doing so is considered criminal as you are basically bearing false witness, even in a court of law.
Whenever you have some transactions to carry out, ensure you make it arm’s length.
Not only will you enjoy better prices or whatever other benefit you stand to gain, but will also avoid investigations by the IRS.