Arm’s Length Transaction is an official term for transactions that takes place between two parties; where each party takes actions in their particular self-interest. It involves two independent parties, i.e. a buyer and a seller that enjoy equal negotiating power. Each party is independent and they face no pressure from the opposing party. The parties make decisions that are within their self-interest in order to achieve a favorable deal.
In the arm’s length transaction, the value of the transaction corresponds with the Fair Market Value of the transaction. Take the example of a buyer and a vendor that acts independently and is unfamiliar with one another. Now, each party would like to negotiate the price to a point where both are satisfied. In other words, each party will want to come to a price that grows their profits.
Let’s understand the concept with an example.
Suppose you are planning to move to another city and you want to sell your residential property before the moving date. Your friend is also on the lookout for a home. You Call an appraiser for the valuation of your house and find out that the actual Market value of your property is INR 50,00,000. Now, your friend does not have a budget to buy your property for such a high price. So, they propose INR 20,00,000. You also receive a bid of INR 45,00,000 for your house from a total stranger. You have two options.
You could sell your property to your friend and help him finance the house for a low price or sell your home to a stranger and make the maximum profit from the deal. If you sell your property to a stranger, you will enjoy the arm’s length transaction. That’s because each party in such a transaction will be considered independent, as they will make decisions to satisfy their self-interest. If you sell your property to your friend, on the other hand, then it will not be considered an arm’s length transaction. That’s because you are not acting for your self-interest, instead, you are selling the property to your friend as he is close to you.
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The deal might be suitable and a lucrative option for your friend as he is getting the property for his desired price. However, it might not be a perfect deal for you.
The organizations that execute each transaction at arm’s length are preferred by the investors. It is important for businesses to conduct all kinds of transactions at an arm’s length in order to garner the attention of the investors. In 2018, Aphria paid more than the required amount to the foreigners for obtaining assets that were of no value. The news made a headline in 2018 and the shares of the company declined by up to 40% in just 2 days. That’s because the transaction was not at arm’s length and it was frowned upon by investors and shareholders of the company.