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In the global business environment today, it is not unusual for subsidiaries of larger companies to conduct business transactions with one another, as if they are not all part of the same corporate family. When two companies that are affiliated by a connection through a parent company, the type of business they transact is often referred to as an arm’s length transaction. The price per unit that is extended for the items bought and sold is referred to as an arm’s length price. Here is some background on how the concept of an arm’s length price works, and why it is considered important.
The basic premise behind the extension of an arm’s length price is to ensure that even though both the buyer and seller companies are affiliated through a parent company, the rates or prices extended will still reflect fair market value. This means that while the subsidiary may be able to enjoy the same volume discounts that may be extended to any customer with a similar pattern of volume purchasing, there will be no special in-house discounts extended. In effect, the arm’s length price is another way of stating that the sister company cannot expect any discounts or price breaks above those that would be extended to any customer.
Extending an arm’s length price essentially accomplishes two things. First, this form of pricing structure is good for the seller. Pressure to supply goods at cost to a sister company would easily drive down profits, and could place the company in a precarious financial position. Second, extending an arm’s length price helps to prevent such matters as questions about taxes from becoming a problem.
Because there is no special price for the affiliated company, there is no need for any government investigations into possible activities that took place to intentionally lower the taxes due by one of more of the affiliated companies. Both reasons also contribute to a third reason. With the extension of an arm's length price, there is no question about conflict of interest. The structure of the trade of products in exchange for revenue is completely transparent, with no hidden motives to be read into the transaction.
Various countries have laws regarding the establishment of guidelines for determining inter-company or arm's length price structures. When dealing with a vendor who happens to be affiliated to the buyer through a third party, it is always a good idea to make sure the pricing that is extended is within the legal perimeters that apply to both the buyer and seller locations.
The definition is quite exhaustive.
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