Non-arm’s length transactions: Overview, definition, and example
What are non-arm’s length transactions?
Non-arm’s length transactions refer to business deals or agreements where the parties involved have a close relationship, such as family members, business partners, or entities under common control. These transactions are not conducted at "fair market value," meaning that the terms of the deal might not reflect what an independent, third-party buyer or seller would agree to under normal circumstances. Because the parties are related or have a vested interest in each other’s financial well-being, the pricing and terms of these transactions may not be negotiated in a typical, unbiased manner.
For example, a company might sell equipment to a family member at a discounted price, rather than at the market rate, which would be considered a non-arm’s length transaction.
Why are non-arm’s length transactions important?
Non-arm’s length transactions are important because they can introduce conflicts of interest, potentially leading to biased decisions that do not reflect the true value of the goods or services being exchanged. In many cases, non-arm’s length transactions are closely scrutinized by regulators and tax authorities, as they can be used to shift profits, avoid taxes, or manipulate financial outcomes. Businesses must disclose such transactions accurately in their financial statements and tax filings to ensure compliance with relevant laws and regulations.
For businesses, understanding the implications of non-arm’s length transactions is crucial for transparency and avoiding legal or tax-related issues. It's also important for maintaining trust with investors, stakeholders, and regulatory bodies.
Understanding non-arm’s length transactions through an example
Imagine a business owner who sells a piece of machinery to their son at a much lower price than the market value. The son, who is not a separate business entity but is closely related to the owner, agrees to the sale under terms that would not typically be available to an independent buyer. This transaction is considered non-arm’s length because the pricing is influenced by the familial relationship rather than an independent market evaluation.
In another example, a company might provide services to a subsidiary at below-market rates. Since both the parent company and the subsidiary are part of the same corporate group, the deal could be viewed as a non-arm’s length transaction, potentially impacting the financial statements of both entities.
An example of a non-arm’s length transaction clause
Here’s how a non-arm’s length transaction clause might look in a business agreement:
"The Company acknowledges that any transaction involving related parties, including but not limited to sales, purchases, or services rendered between the Company and its affiliates, directors, officers, or their immediate family members, shall be disclosed as non-arm’s length transactions and accounted for in accordance with applicable accounting standards and regulatory requirements."
Conclusion
Non-arm’s length transactions are transactions between related parties where the terms may not reflect fair market value due to the closeness of the relationship. While such transactions are common in family-owned businesses and between affiliated companies, they require careful attention and transparency to avoid legal and tax issues. Understanding the nature of non-arm’s length transactions ensures businesses can maintain compliance and avoid conflicts of interest, ensuring that all dealings are properly documented and reported.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.