Arm’s length transactions occur when subsidiaries of a larger company conduct business as if they are not part of the same corporate family. The arm’s length price ensures fair market value and prevents special discounts. This pricing structure benefits sellers, avoids tax issues, and eliminates conflicts of interest. Countries have laws regarding arm’s length pricing guidelines.
In today’s global business environment, it is not unusual for subsidiaries of larger companies to conduct business transactions with each other, as if they are not all part of the same corporate family. When two affiliated companies have a connection through a parent company, the type of business they transact is often referred to as an arm’s length transaction. The extended unit price for items bought and sold is referred to as the arm’s length price. Here’s some background on how the concept of arm’s length pricing works and why it’s considered important.
The basic premise behind arm’s length pricing extension is to ensure that even if the buying and selling companies are affiliated through a parent company, the extended rates or prices still reflect fair market value. This means that while the branch may be able to enjoy the same volume discounts that can be extended to any customer with a similar volume buying pattern, internal special discounts will not be extended. In fact, arm’s length pricing is another way of stating that the subsidiary cannot expect any discounts or price reductions beyond what would be extended to any customer.
Market price extension essentially accomplishes two things. First, this form of pricing structure is good for the seller. The pressure to supply goods at cost to a subsidiary would easily reduce profits and could put the company in a precarious financial position. Second, the market price extension helps keep issues like tax questions from becoming a problem.
Since there is no special affiliate pricing, no government investigation into possible activities that have taken place to intentionally lower the taxes owed by one or more affiliates is unnecessary. Both reasons also contribute to a third reason. With the market price extension, there is no question of conflict of interest. The structure of trading products for revenue is completely transparent, with no hidden motives to read into the transaction.
Several countries have laws regarding the establishment of guidelines for determining intercompany or arm’s length pricing structures. When dealing with a seller affiliated with the buyer through a third party, it’s always a good idea to make sure that the extended price falls within the legal perimeters that apply to both the buyer and the seller.
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