Legal Definitions - arm's-length price

An arm's-length price refers to the price agreed upon in a transaction between two independent, unrelated parties who are acting in their own self-interest. It is the fair market value that would be established if the buyer and seller had no pre-existing relationship or special influence over each other. This concept ensures that transactions are conducted on commercial terms, free from any bias or favoritism that might arise from a close connection.

Here are some examples to illustrate this concept:

• Example 1: Real Estate Sale Between Family Members

  Imagine a situation where a father decides to sell a piece of land to his daughter. To ensure the transaction is considered legitimate and fair for tax purposes, they agree to an arm's-length price. This means they would determine the land's value by looking at recent sales of similar properties in the area, getting independent appraisals, or consulting real estate agents, rather than simply agreeing on a low price out of familial affection. The price the daughter pays would be what any unrelated buyer would pay on the open market.

  This illustrates the term because the father and daughter, despite their relationship, are treating the sale as if they were strangers, ensuring the price reflects true market value and avoids potential issues with tax authorities who might otherwise view it as a partial gift.

• Example 2: Intercompany Transactions for Tax Purposes

  Consider a large multinational corporation with a manufacturing subsidiary in one country and a sales subsidiary in another. The manufacturing subsidiary produces goods and sells them to the sales subsidiary. For tax authorities to be satisfied that profits are not being unfairly shifted between countries to minimize tax, the price at which the manufacturing subsidiary sells goods to the sales subsidiary must be an arm's-length price. This means the price should be comparable to what the manufacturing subsidiary would charge an entirely independent, unrelated company for the same goods under similar conditions.

  This demonstrates the term by showing how related entities must transact as if they were independent to prevent artificial manipulation of prices for tax advantages, ensuring each part of the business pays its fair share of taxes based on genuine market transactions.

• Example 3: Loan Between a Business Owner and Their Company

  Suppose a small business owner lends money from their personal savings to their struggling company to keep it afloat. To ensure the loan is treated as a legitimate business expense for the company (e.g., interest paid is deductible) and not a disguised capital contribution, the interest rate charged on the loan should be an arm's-length price. This means the interest rate should be similar to what a bank or an unrelated commercial lender would offer for a loan of that size and risk profile, rather than an arbitrarily low or zero-interest rate.

  This example highlights the term by showing that even when an individual and their own company are involved, the financial terms must mimic those of independent parties to maintain legal and tax validity, preventing the owner from gaining an unfair personal advantage or tax benefit.