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Arm’s Length Transaction

Updated on May 16, 2024
Article byNiti Gupta
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Arm’s Length Transaction?

Arm’s length transaction means a transaction between two enterprises, such that the parties act independently, and the price agreed between them (also known as transfer price) is free from any influence that maybe they’re due to the relation between parties who are not independent.

In other words, this transaction is the one that is done at a fair value. A transaction can be at arm’s length only when the parties to the contract do not influence each other in any way. If the parties are related to each other, or one party can influence the other, then prices decided will not be equal to fair value but will be influenced owing to the relationship that exists between the parties.

Example

A company named ABC Inc, USA, entered into a contract with its subsidiary company ABC Inc, the Netherlands, for the purchase of raw material. The price per kg of raw material was decided for $10. Had ABC Inc USA purchased the raw material from other vendors supplying the same raw material located in the Netherlands, they would have got the raw material at a price of $7 per kg.

Here, ABC Inc, USA, has tried to increase its expenses by purchasing from a related party at a higher price ($10) than the fair price ($7). By doing so, it has attempted to shift its profits to its related party located in the Netherlands (a tax heaven country). Clearly, the motive is to save taxes in the USA and shift the profits to the Netherlands, which is a tax haven.

The transaction between ABC Inc, USA, and ABC Inc., the Netherlands is not at arm’s length. Had the price agreed between them would have been within a reasonable range of $7, then it would have been at arm’s length.

Arm's-Length-Transaction

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Source: Arm’s Length Transaction (wallstreetmojo.com)

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Importance of an Arm’s Length Transaction

The main reason why transactions between related parties are not at arm’s length is their motive to minimize their global tax expenditure. The unfair pricing may lead to loss of tax revenue for states. It happens as the parties to the transaction will tend to shift their profits to states with lower tax rates, by fixation of the prices in a favorable manner.

In such a case, an MNC will strategize to lower its global tax burden by encouraging transactions between related parties at unfair prices. Thus, in order to ensure that profits are fairly distributed by the multinational companies, the concept of transfer pricing was adapted so that the tax authorities of respective states get their fair share of tax revenue.

Thus, an arm’s length price is adopted, which acts as a base for its classification. The arm’s length price is adopted using various methods as per transfer pricing regulations. It reflects the fair value of the transaction.

Arm’s Length vs. Non-Arm’s Length Transaction

ParticularsArm’s Length TransactionNon-Arm’s Length Transaction
Parties to transactionMostly unrelated entitiesRelated entities
Nature of transfer priceFair priceInfluenced price
Shifting of profitsIt does not lead to the shifting of profits by an entity.It may lead to shifting of profits by an entity.
A loss to tax authoritiesIt doesn’t cause any loss to tax authorities.It causes loss to tax authorities.
Tax adjustmentNo additional tax adjustment will be there.Tax will have to pay after making transfer pricing adjustments.

Conclusion

Thus, globally the tax authorities are ensuring the scanning for any taxpayers who have not made transactions at arm’s length. The tax is then determined to be paid by the taxpayers considering the fair value (known as arm’s length price) of the transaction using the most suited method. This places the related as well as unrelated parties at an equal footing in terms of taxation and pricing.

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