Arm’s Length Transaction Definition
In real estate, an arm’s length transactions refers to a business deal where parties involved have no previous relationship prior to the sale and exchange of the underlying property. These types of transaction are free from influence and the property being sold is likely to attract a fair market value compared to when parties are related.
Consequently, transactions involving family members or companies with related shareholders (Subsidiaries) are not considered arm’s length transactions. This is because it’s highly unlikely that a transaction involving such a group would yield a sale price that is close to a fair market value compared to a deal between strangers. A business deal involving parties with pre-existing relationship are known as arm-in-arm transactions.
Nevertheless, it doesn’t mean that all arm-in-arm transactions won’t necessarily attract a fair market value. Also, it doesn’t mean that transactions between related parties cannot be construed to be an arm’s length transaction despite them having a pre-existing relationship. We shall discuss the arm’s length principle in detail to better understand how it works.
A Little More on What is an Arm’s Length Transactions
An arm’s length transaction provides a level of assurance that a property being exchanged for valuable consideration will attract a fair market value. Tax authorities throughout the world always try to ensure that transactions, whether between related parties or strangers, are transacted at an arm’s length at least for tax purposes and to deter fraud.
Fair Market Value refers to the price an asset would attract in the open market when parties transacting are assumed to be acting on their own best interest and free from undue influence or pressure to trade at a lower price than the existing market or appraised value. Therefore, from the foregoing, an arm’s length transaction can alternatively be defined simply as one that meets fair market value.
Non-Arm’s Length Transactions (Arm-in-Arm Transactions)
There is not a single universal rule that list relationship that should be considered non-arm’s length transaction if parties to a particular relationship were to transact. This is because of certain underlying considerations that may modify how a relationship is construed. For instance, parties may be having a pre-existing relationship but still achieve an arm’s length transaction.
However, it is a thumb rule, that parties who are having business transaction and have pre-existing relationships, either personal or professional, the transaction is assumed to be a non-arm’s length transaction. Some of those relationships commonly considered more qualifying as non-arm’s length relationships include:
- Transactions between members of the same family
- A subsidiary or affiliate company and their parent company
- Principal owners of business entities, and their family members
- Management of an entity, and their family members
- Wards and their legal guardians
- The trustees and beneficiaries of the trust, and;
- Employees and their employers
Generally, parties that fall in any of the above listed categories if they were to exchange assets, there is a high likelihood that there would be an imbalance of power – where one party may exert control over the other. Additionally, there is the risk of collision resulting in concealment of material fact as well as manipulation of pricing to cater for hidden agendas.
Nevertheless, it doesn’t mean that parties that fall in any of the above listed categories shouldn’t transact or any transaction shall be deemed illegal. Of course, it is easy for such parties to transact and the seller due to the existing personal connection is sympathetic to the buyer and offers substantial discounts when contracting. Alternatively, the buyer may be the one sympathetic to the seller’s situation, and may end up overpaying the seller. However, there are taxation risks or consequences that the seller will likely face.
For instance, using the example presented above, if a father sold a property to his son at a discounted rate, tax authorities will likely exercise their authority and force the father to pay taxes on the gains that is estimated the father would have received if the property was sold in the open market to a neutral party and disregard the actual price paid by the son. This means that the father would be at a loss since the taxes are based on fair market value not the discounted value.
One should consult with a tax professional on the intricacies of tax authority’s special treatment of property transfers between related parties. Generally, these transfers can have significant tax implication to both the buyer and the seller. For example, capital gains from transaction between a mother and her daughter may be treated as ordinary income, restricting the use of like-kind exchanges, as well as characterizing the sale as a gift.
So, is it possible for parties with a pre-existing relationship to have an arm’s length transaction? Well, there is a way. Apart from avoiding the scrutiny of internal revenue services (IRS), having an arm’s length transaction guarantees an aggrieved party to any contract of just compensation in case things don’t work out and one decides to litigate.
Generally, things tend to get ugly in court whenever there is a question as to whether a contract is an arm’s-length transaction since the possibility of conflict of interest suffices. Below are some suggestions to make sure business contracts between related parties are negotiated at arm’s length;
- Get an independent appraisal – If one is buying or selling a property, it is advisable to get an independent real estate appraisal. On the other hand, if you are buying or selling a business, get a business valuation.
- Get independent negotiators – each part should have their own lawyer or broker and let the professionals do most of the negotiating.
- Put it in writing – No handshake deals or oral contracts. It is advisable to ensure that every element of the contract is spelled out. Also, if there are any special considerations, they should not be hidden but rather they can be included to the contract as an addendum.
Arm’s Length Transaction Requirement by Lenders
Mortgage lenders in an attempt to curb fraud may scrutinize contracts to ensure the same is an arm’s length transaction. Persons related can in the disguise of doing a legitimate transaction scheme to defraud a lender. Also, crooks can smell homeowners who are in distress and staring at a possibility of a foreclosure and consequently device a scheme to take advantage of the situation.
Generally, after three to six months of missed mortgage payments, a lender will issue a Notice of Default with the County Recorder’s Office. This notice is to let the homeowner know he/she is at risk of foreclosure, usually through a public auction, and consequently an eviction. When the homeowner gets the notice he/she has the option to try and settle with the bank by way of a short sale prior to the foreclosure.
A short sale means that a homeowner will sell the property with the approval of the lender at close to market value. However, the homeowner owes more on the mortgage balance than the market value or sale price of the property at the time the owner wants to sell. Nevertheless, the lender agrees to take the amount as full settlement for the debt although “short” on paying back the total mortgage owed. Generally, because the lender believes the cost of foreclosing, and then reselling, the property would be more expensive than accepting the loss on the loan repayment.
This is where the possibility of a fraud comes in. For instance, a homeowner who has the approval from a lender to do a short sale may collude with relatives or friends to masquerade as interested purchaser when in reality they are straw buyers to the property. After purchasing the property at probably a reduced price even half, the buyer will transfer back the title to the property to the seller later. This means that the lender has been deceived into a short sale and consequently accepting less money than what was owed.
Another fraud by related parties, not necessarily involving a short sale, is where related parties may device a financing scheme to fleece a lender. For instance, company can be formed to acquire a commercial building and make relevant applications for financing from a lender to acquire the property. However, months later the company defaults to make repayments, upon investigations the lenders discovers that that the company’s managing director is the brother to the seller and the property value was inflated.
Consequently, it means that the lender has been deceived into financing a property that is worth less than the outstanding loan amount and even a foreclosure will still mean a loss. Because of the possible risk of fraud, a lender may require related parties to a mortgage transaction to provide a host of documents to verify that the transaction being undertaken is an arm’s length. The following are common requirements:
- A duly executed copy of the contract between the buyer and the seller.
- An independent property appraisal of the underlying asset or property.
- A duly executed affidavit of arm’s length transaction disclosing the parties’ relationship.
- Where the parties are related, an Independent verification that the sales price is close to fair market value by comparing the contract terms with those of a similar transaction, but with unrelated parties.
What an Arm’s-Length Affidavit Contains
Most lenders draft their own affidavits. The language use may vary from one lender to the same although there is consistency to what generally an arm’s length affidavit contains. However, the specifics are not negotiable at all. Below are what to expect in a basic arm’s length affidavit:
- It references the property address, names of the sellers, buyers, agents, and the fact that it is an arm’s-length transaction.
- Paragraphs stating that no person to the contract ,if it is a short sale for instance, is a family member or business associate or having a shared interest to the seller.
- A clear indication that there are no hidden terms or special agreement between the parties to the contract in question.
- If it is a short sale, a condition that once the transaction closes, the sellers will not rent back the home or try to regain title to it, unless with the approval of the lender.
- That none neither the buyer nor the seller will receive any compensation for the transaction except for the commission paid to the agents.
Once parties sign the arms-length affidavit especially for a short sale and then violates it, they could be held liable for mortgage fraud. Mortgage fraud falls under the jurisdiction of the Federal Bureau of Investigations (F.B.I).If one is found guilty after investigations the fines are as high as one million dollars for each count of fraud and a possibility of been incarcerated for thirty years.
Transfer Pricing and Arm’s Length Principle
Multinational companies with subsidiaries spread across several countries often transact among each other. The fact that this companies share a common ownership means that as a rule, the transaction is an arm in arm transaction, and there is a risk to distort pricing of items transacted for tax benefits.
Transfer pricing refers to an accounting method for setting prices for goods and services that are exchanged within and between enterprises under common ownership or control. Generally, the pricing are calculated using one or more of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations methods issued by the Organization for Economic Co-operation and Development (OECD), a Paris-based organization of 34 countries.
Tax authorities in different countries require transfer prices to be at an arm’s length so that each country affected can collect the right taxable amount. In case of distortion, the tax authority may move to court to seek a fair market value of the transfer price for what would have been charged by unrelated enterprises dealing at arm’s length.
Besides, tax authorities have always viewed transfer pricing as a tax saving means and may contest claims by multinationals. For instance, several corporations including Coca Cola, Google’s parent company Alphabet inc, Facebook, and GlaxoSmithKline among other have pending tax litigation due to transfer pricing which the tax authority feels were not transacted at arm’s length.
S&P Home Indices and Arm’s length Principle
S&P CoreLogic Case-Shiller Home Price Indexes are designed to be a reliable and consistent benchmark that measure increases or decreases in the market value of residential real estate in defined regions prices in the United States. In the 1980s, during the housing price boom in Boston, Economists Karl Case and Robert Shiller in an effort to study home pricing trends in the United States developed a method for comparing repeat sales of the same homes.
That methodology is what is commonly referred to as the Case–Shiller home price index. These are a group of indexes that measure or track the average changes in the prices of single-family-detached residences (houses) throughout the United States by observing the purchase price and resale value of those houses that have undergone at least two arm’s length transactions.
The Analysts at CoreLogic as well as those at S&P are the ones that produce the ratings monthly and quarterly based on the data from local government assessor and records offices that identifies homes that have been subjected to an arm’s length transactions for obvious reasons .Such transactions are free from undue pressure or control and the home being sold is likely to attract a fair market value and therefore reliable in tabulating data.
In conclusion, the arm’s length principle from the foregoing is an important aspect in real estate and tax. Violating the arm’s length principle whether willfully or out of ignorance has negative implications. So next time you are transacting with a family member or associates ensure personal relationship does not cloud your judgment to avoid being barred from lending or worse coming under the scrutiny of the IRS.
References for Arms Length Principle
Academic Research for Arm’s Length Principle
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The arm’s length principle and distortions to multinational firm organization, Keuschnigg, C., & Devereux, M. P. (2013). The arm’s length principle and distortions to multinational firm organization. Journal of International Economics, 89(2), 432-440.
The arm’s length principle, transfer pricing, and location choices, Yao, J. T. (2013). The arm’s length principle, transfer pricing, and location choices. Journal of Economics and Business, 65, 1-13.
Arm’s length relationships, Crémer, J. (1995). Arm’s length relationships. The Quarterly Journal of Economics, 110(2), 275-295.
The distorting arm’s length principle, Devereux, M. P., & Keuschnigg, C. (2009).
Denmark, Sweden and Norway: Television diversity by duopolistic competition and co-regulation, Lund, A. B., & Berg, C. E. (2009). International communication gazette, 71(1-2), 19-37.
International Transfer Pricing: Pointers Towards Balance of Payment Issues of an Economy, Pendse, S., & Gole, P. (2012).
Sorting into outsourcing: Are profits taxed at a gorilla’s arm’s length?, Bauer, C. J., & Langenmayr, D. (2013). Journal of International Economics, 90(2), 326-336.
Multinational pricing: How far is arm’s length?, Keegan, W. J. (1969). The International Executive, 11(4), 19-21.
Transfer pricing, the arm’s length standard and European Union law, Schön, W. (2013). In Allocating Taxing Powers within the European Union (pp. 73-99). Springer, Berlin, Heidelberg.
Transfer pricing and tax avoidance: Is the arm’s-length principle still relevant in the e-commerce era, Oguttu, A. W. (2006). S. Afr. Mercantile LJ, 18, 138.