What Does Arm's Length Transaction Mean?

What Does Arm's Length Transaction Mean?

A transaction in which the buyers and sellers of a product act independently and have no relationship to each other. The concept of an arm's length transaction is to ensure that both parties in the deal are acting in their own self interest and are not subject to any pressure or duress from the other party.

Investopedia Says

Investopedia explains Arm's Length Transaction

The concept of an arm's length transaction commonly comes into play in the real estate market. When determining the fair market value of a piece of property, the price for the property must be obtained through a potential buyer and seller operating through an arm's length transaction, otherwise, the agreed-upon price will likely differ from the actual fair market value of the property.

For example, if two strangers are involved in the sale and purchase of a house, it is likely that the final agreed-upon price will be close to market value (assuming that both parties have equal bargaining power and equal information about the situation). This is because the seller would want a price that is as high as possible and the buyer would want a price that is as low as possible.

This contrasts with a situation in which the two parties are not strangers. For example, it is unlikely that the same transaction involving a father and his son would yield the same result, because the father may choose to give his son a discount.

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The role of multinational enterprises (MNEs) in world trade has increased dramatically over the last 20 years. For MNEs, specific problems regarding taxation arise at both policy and practical levels. At the policy level, countries need to reconcile their legitimate right to tax the profits of a taxpayer based upon income and expenses that can reasonably be considered to arise within their territory with the need to avoid the taxation of the same item of income by more than one tax jurisdiction. At a practical level, the taxing rights that each country asserts depend on whether the country uses a system of taxation that is residence-based, source-based, or both. OECD member countries have chosen a separate entity approach as the most reasonable means for achieving equitable results and minimising the risk of unrelieved double taxation. Thus, each individual group member in an MNE is subject to tax on the income arising to it (on a residence or source basis). To ensure the correct application of the separate entity approach, OECD member countries have adopted the arm's length principle, under which the effect of special conditions on the levels of profits should be eliminated.

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