When drafting a contract, especially in business, real estate, or tax-sensitive transactions, you may come across the term “Arm’s Length Transaction.” It sounds like another boiler plate clause, and it is. Here’s an example of an Arm’s Length Transaction Clause:
“The Parties certify that each (1) has had the opportunity to obtain separate and independent counsel of their own choosing prior to executing this Agreement and has either exercised or waived such right; (2) has had an opportunity to negotiate terms under this Agreement; and (3) agrees that any ambiguities shall not be construed against the other Party.”
This short clause packs a serious punch in terms of legal protection and clarity. So, what does it mean, and why is it so important? An Arm’s Length Transaction is one in which the parties are independent, unrelated, and acting in their own best interest. This means there’s no hidden relationship, special treatment, or undue influence impacting the deal. This is important when there is a dispute, and the contract needs to be enforced. This term establishes that both sides agree that they negotiated fairly, neither side was pressured into the agreement, and the terms reflect those on which independent actors on the open market would agree.
What can go wrong without it? If this clause is missing or poorly written, it can open the door to many types of problems. First, in a legal dispute, a party can allege that the contact is unenforceable because of the leverage or influence that one party had over the other party leading to coercion. A court may suspect that the deal wasn’t fair, especially if there is a special relationship between the parties, or one side had a lot more power. This could lead to a contract being challenged or even voided.
Second, tax authorities like the IRS or local equivalents (like the Department of Revenue in Washington) rely heavily on arm’s length standards when reviewing transactions between related entities. If a deal isn’t clearly structured at arm’s length, it could result in reassessed income, penalties, or massive tax bills. Parties may try and structure an agreement to minimize taxable events in ways that could cause problems.
Third, imagine that a company is struggling financially and is close to declaring bankruptcy. A director has a brother who owns another business and just before the struggling company files for bankruptcy, it sells a valuable piece of machinery to the other business for what seems like a low amount. This sale could be seen as a fraudulent conveyance, and possibly tax evasion, if the asset was sold for far less than its fair market value. If the struggling company conducted the sale at arm’s length, it would have obtained an independent appraisal, advertised the sale publicly and solicited multiple offers, and sold the asset to the highest bidder. In this way, the transaction would not favor the insider (the director’s brother), and the company would receive fair value, protecting the interests of creditors.
Still not convinced this matters? Courts have reversed property transfers between family members due to lack of arm’s length negotiation, especially in divorce, inheritance, or creditor situations. Here are some high-profile examples where the “Arm’s Length” principle played a major role.
GlaxoSmithKline vs. IRS: The pharmaceutical giant settled a $3.4 billion dispute over transfer pricing, all hinging on whether their inter-company pricing reflected arm’s length standards.
Chevron Australia Holdings Pty Ltd v Commissioner of Taxation: Chevron was hit with over $1 billion AUD in back taxes because a loan from its U.S. subsidiary was found to be at non-arm’s length interest rates.
When drafting or reviewing a contract, make sure the transaction and the Arm’s Length Transaction clause is clear and solid. A good clause should affirm that both parties have equal footing, there is no special relationship or coercion, and each party has access to independent legal and financial advice.
The “Arm’s Length Transaction” clause might seem small, but it plays a huge role in protecting deals from legal and financial headaches down the road. Think of it as the legal world’s version of saying, “No funny business here.” Whether you’re working on a business transaction, real estate deal, or contracting for services, don’t overlook this powerful little paragraph.
This blog is for general information purposes only and should not be relied upon as specific legal advice. This article, or contacting Apex, does not in any way form an attorney-client relationship. If you have any questions or would like to learn more or help drafting or improving your contracts, please contact us or visit our blog.