What is an arms length transaction?

Answer 1

An arm's length transaction is a transaction that occurs between two unrelated parties, each of whom is acting in their own self interest and therefore trying to get the best deal for themselves, when a transaction is arm's length, the amount exchanged for it is considered to be fair market price.

With that said, a NON arm's length transaction is one that occurs between related parties (when one entity has the ability to influence the decision making of another such as friends, family, sister corporations, etc). When a transaction takes place between related party it cannot be assumed that the transaction amount is the fair market value because both parties are not working in their own interest.

For example, your mother may be being generous when selling you her car by giving you a large discount, or you might be doing her a favour and paying her more than it is worth.

Arm's length is the legal description of an agreement made freely, for fair market consideration and when there is no special relationship between the parties. It can becomes an important consideration when other issues are present.

For example, a sale of a property for fair consideration to a third party would be an arm's length transaction. A sale of the land for a minimal price from a father to his daughter would not. In some circumstances such as a transfer to avoid creditors the second transaction could be nullified by a court.