What is an Arm’s Length Transaction?
An arm’s length transaction refers to a business deal where buyers and sellers act independently without influencing each other. These transactions ensure that both parties act in their own self-interest and are free from pressure or collusion. They also provide assurance that there is no undue influence between the buyer and seller. Typically, both parties have equal access to information related to the deal, promoting fairness.
Key points:
- An arm’s length transaction involves parties who act independently of one another.
- The parties usually have no prior relationship.
- In real estate, these deals help ensure properties are priced at fair market value.
- Arm’s length transactions can impact financing and taxes.
- Transactions between family members or companies with related shareholders are not considered arm’s length.
Understanding Arm’s Length Transactions
Arm’s length transactions find extensive use in real estate dealings due to their impact not only on the involved parties but also on entities like lenders.
In a scenario where two unfamiliar individuals engage in a home sale, the final negotiated price typically aligns closely with the property’s fair market value (FMV), given both parties possess equal bargaining power and access to the same property information. The seller aims for a higher price while the buyer seeks a lower one, ultimately resulting in an agreed-upon price closely reflecting the property’s FMV.
It’s crucial to note that in arm’s length transactions, the influence extends beyond the buyer and seller. This transaction type significantly affects the financing obtained from your preferred bank and also holds sway over state and council rates. Additionally, it can impact the market’s comparable prices, making it a multifaceted component in real estate transactions.
What are Non-Arm’s Length Transactions?
A “non-arm’s length” transaction, often called “arm-in-arm transaction,” occurs when the buyer and seller share a relationship, whether personal or professional. This relationship may involve family ties, business partnerships, or close friendships. Such close associations can result in prices that deviate from the fair market value of the property and, in severe instances, may even lead to fraudulent practices.
Arm’s Length vs. Non-Arm’s Length Transactions
An established relationship often influences the terms of a non-arm’s length transaction. For instance, a transaction involving a father and his son is unlikely to mirror the outcome of a deal between unrelated parties, as the father might opt to offer his son a discount.
In scenarios where the sale of a house occurs between family members and is subject to taxation, tax authorities may require the seller to report taxes based on the profit that would have been earned if the property was sold to an unrelated third party. The actual price paid by the son might be disregarded in this assessment.
Similarly, international transactions between non-arm’s-length entities, such as two subsidiaries under the same parent company, must adhere to arm’s length pricing. This practice, referred to as transfer pricing, ensures that each country appropriately taxes these transactions.
What is Fair Market Value (FMV)?
The fair market value (FMV) denotes the price at which a product would be sold in an open market, assuming both buyer and seller possess reasonable knowledge about the asset, act in their own best interests, face no undue pressure, and are given a reasonable timeframe to finalise the transaction.
Under these circumstances, the fair market value of an asset should present an accurate evaluation or estimation of its value.
Reconciling Arm’s Length Transactions with FMV
One of the primary advantages of arm’s length transactions lies in their fairness and impartiality, particularly evident in real estate transactions. When the buyer and seller lack prior connections, FMVs are the decider.
The FMV represents the most suitable price that an unbiased, neutral seller and buyer would agree upon to finalise the transaction. Several factors contribute to determining the FMV of a house and lot, including:
- Location (city, neighbourhood)
- Comparative home prices
- Property condition and age
- Structure area, acreage and amenities
- Property renovations and enhancements
Naturally, other variables, such as prevailing interest rates and the broader economic climate, also factor into the determination of a home’s FMV.
Example
Let’s illustrate how arm’s length transactions operate using a hypothetical scenario. Building upon the previous example involving a father and son in a real estate transaction, let’s identify them as John Willoughby and his son Neville from North Maleny, Queensland.
Imagine John decides to sell the family farm property fronting Lake Baroon and lists the 45-acre complex for $4m, an amount aligned with the fair market value (FMV). An interested buyer offers this amount after considering various factors impacting the property’s worth, such as its location, amenities, and going rates for farming properties in the general Maleny area. If this offer proceeds to completion, it qualifies as an arm’s length transaction.
However, Neville makes his dad an offer for the property at $3.75m, citing their familial relationship. Should John agree to this lower offer, it would constitute a non-arm’s length transaction due to their familial ties influencing the deal.
Conclusion
In the intricate tapestry of Australian business practices, the significance of arm’s length transactions cannot be overstated. Upholding the principles of independence, fairness, and transparency lays the foundation for a robust and ethical business ecosystem.
DISCLAIMER: This article is for informational purposes only. The persons in the example presented do not represent any actual people or property listing.
