Concepts
Arm's length
Dealing at arm's length means two parties act independently, each pursuing their own interests, so that the terms and price reflect what unrelated parties would agree.
A transaction is at arm's length when the parties deal with each other as independent parties would, each seeking the best outcome for themselves and neither able to dictate terms to the other. A sale between two unrelated businesses at a negotiated price is the classic example. The opposite is a non-arm's length dealing, where a relationship, such as family, common ownership or control, influences the terms.
The concept is used throughout the tax system as a benchmark. Where parties are not dealing at arm's length, tax rules often step in to ensure that the outcome reflects what would have occurred between independent parties. This can mean substituting market value for the actual price, adjusting how income is split, or limiting a deduction. The idea is to prevent tax outcomes being distorted by relationships.
In practice, the test looks at the circumstances of the dealing, not just the price. Factors can include whether the parties are related, whether the price is a market price, whether commercial terms such as interest, security and repayment dates have been included, and whether the dealings are documented. A transaction between relatives can still be at arm's length if the terms are genuinely commercial, though the closer the relationship, the more evidence you may need.
For GST, the arm's length idea is relevant in several places. Where a supply is made to an associate for no consideration or for less than the market value, the law may treat the value as the market value in certain circumstances. Rules for some transactions, such as the sale of property or the supply of goods between associated entities, also depend on whether the dealing was between parties who were not at arm's length. The specific rule determines what happens, so check the relevant guidance.
The ATO also uses the concept in areas such as transfer pricing, where related entities in different countries deal with each other. Prices charged between related entities are expected to be those that independent parties would agree. Smaller businesses encounter the idea more often in everyday matters, such as selling a business asset to a family member, paying a relative's wages, or charging rent to a related business.
A common misunderstanding is believing that a written contract by itself makes a transaction arm's length. The terms must be commercially realistic. Another is believing that dealing with family is always a problem. It is not, if the terms are those an independent party would accept and you can show it. Keep valuations, quotes and comparisons on file. This is general information only, so confirm how the arm's length test applies to you with the ATO or a registered tax professional.
Worked example
A business sells a delivery van to the owner's brother. Independent dealers value the van at about $22,000, but the brother pays $12,000. Because the parties are not dealing at arm's length, the tax outcome may be worked out using the $22,000 market value rather than the $12,000 price. The difference of $10,000 is treated as part of the proceeds for the purposes of income tax calculations.
Practical tips
- Keep a record of how you set the price, such as quotes, valuations or comparable sales.
- Include normal commercial terms in dealings with related parties, such as repayment dates and interest on loans.
- Ask a tax professional before selling an asset to a relative or related company at a discount.