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An arm's length transaction is overseen by the arm's length principle of transfer pricing. Transfer pricing is settlement of charges when a transaction between two entities. An arm's length transaction ensures that a transaction is completed at fair market value. That means the two related entities are not working on a discounted or inflated price simply because the two sides have a relationship.
A high profile case of an arm's length transaction took place in Canada recently with drug company GlaxoSmithKline. It purchased a key ingredient for a popular heartburn treatment product from a European arm of its UK-based parent company. The Canadian company paid a significantly higher price than the generic, market-value price. In court, it was ruled that the price paid was not reasonable in comparison to the generic value. However, upon appeal in 2010, it was ruled the transaction was legitimate because of "business realities," such as a license agreement. As of mid-2011, the case will be sent back to the
Tax Court of Canada for reconsideration.
Arm's length transactions are common place in real estate. Two related businesses may conduct deals for office space or other properties. Or, this may take place between members of family. For example, a parent may sell his child the family home, but at a discounted rate. This would not be an arm's length transaction because the two sides are helping each other and the property, if it was on the open market, it would command a much higher price from anyone else.
Arm's length transactions are essential to establishing a clear and competitive trading market. When conducting transactions, both sides will look to the market to set the price. For example, in real estate, the price of your home will mostly depend on for how much homes around you sell. If these homes are being sold for significantly less -- or more -- then that creates an unbalanced marketplace. What becomes market value is skewed to those conducting transactions without a relationship.