The Federal Constitutional Court (in German "Bundesverfassungsgericht or short "BVerfG"), in its decision dated May 27, 2025 (2 BvR 172/24; published on July 7, 2025), overturned and remanded the judgment of the Thuringian Fiscal Court from March 30, 2022 (1 K 68/17) due to a violation of section 3 (1) of the Basic Law (in German "Grundgesetz" or short "GG") in its manifestation as a prohibition of arbitrariness. The subject of the constitutional complaint by the complainant (entrepreneur) was the non-recognition of start-up losses of an affiliated manufacturing company (toll manufacturer) as its own operating expenses due to the absence of a corresponding written agreement between the two companies.
Underlying Facts
The complainant (GmbH & Co. KG) trades lumber worldwide and serves as the entrepreneur of the group. It handles the procurement of raw timber and performs all centralized group functions as the administrative center. An affiliated company (GmbH & Co. KG) operates as a toll manufacturer for the entrepreneur and runs a sawmill on its behalf. The entrepreneur is also responsible for the planning and construction of the sawmills.
In 2005, the entrepreneur planned and constructed a sawmill for the affiliated company. During this process, there were inadequate planning and implementation deficiencies by the entrepreneur, which led to extraordinary additional costs of more than 4 million euros for the affiliated company. In 2008, the two associated companies reached an "Agreement on Deficit Compensation," and the entrepreneur paid the affiliated company compensation of 4 million euros. The entrepreneur declared this payment as its own operating expenses in its tax returns. There were no written contracts between the two associated companies regarding this matter.
Initially, these operating expenses were considered by the tax authority as declared and were assessed subject to review. During an external audit, the tax authority concluded that no written contract regarding the planning and construction of the sawmill had been established, making it impossible to verify that the process was conducted as would be customary between unrelated parties. Consequently, the tax authority denied the deduction of operating expenses and issued corresponding amended notices.
The entrepreneur filed an objection against this decision, arguing, among other things, that as the entrepreneur, it bears the manufacturing risks and has made the relevant decisions, while the affiliated company acts only as a toll manufacturer and therefore should not bear any start-up losses. According to the "Administrative Principles for Transfer of Function" (BMF dated October 13, 2010 - IV B 5 - S 1341/08/10003 BStBl 2010 I p. 774), such a toll manufacturing relationship can arise from actual practice. In the decision on the objection dated December 28, 2016, the objections were dismissed as unfounded because, without a written contract, the details of the agreement are not verifiable, and such an oral agreement contradicts the arm's length principle.
The complainant subsequently filed a lawsuit with the fiscal court (in German “Finanzgericht" or short “FG"), extending it to cover all start-up losses amounting to 7.5 million euros. During the oral hearing, the complainant provided evidence that it was solely responsible for the construction and maintenance of the sawmill, including the circumstances causing the start-up losses. Additionally, the complainant submitted evidence requests regarding the actual dependency on instructions and the lack of procurement risk for the affiliated company. In its judgment dated March 30, 2022 (I K 68/17), the FG dismissed the lawsuit and did not allow an appeal to the Federal Fiscal Court (in German "Bundesfinanzhof" or short "BFH"). The FG stated that the business justification for the compensation payment must be examined based on the arm's length principle. This examination includes whether the agreement is legally valid, clear, and unambiguous, and whether its content corresponds to what is customary between unrelated third parties and was actually implemented (reference to BFH, judgment dated July 29, 2015 – IV R 16/12 – para. 17). The oral agreement does not meet these requirements, making the actual practice of a toll manufacturing relationship irrelevant.
The complainant filed a non-admission appeal with the BFH against this decision, arguing, among other things, that there was a divergence in case law (Section 115 (2) No. 2 Case 2 FGO) because the necessary examination of the requirements of the arm's length principle was not conducted, focusing solely on the absence of a written agreement. This contradicts the case law of the BFH (judgment dated January 24, 1990 – I R 157/86 – BStBl. II 1990, p. 645 and May 12, 2016 – IV R 27/13– BFH/NV 2016, p. 1559) as well as the BVerfG (decision of the 1st Chamber of the 2nd Senate dated November 7, 1995 – 2 BvR 80/90). The BFH dismissed the non-admission appeal as unfounded with its decision dated March 8, 2023 (IV B 35/22). An objection to the hearing was also dismissed by the BFH with its decision dated May 25, 2023 (IV S 10/23).
Constitutional Complaint at the BVerfG
In its decision dated May 27, 2025 (2 BvR 172/24), the BVerfG ruled that the judgment of the FG violated the general principle of equality (Section 3 (1) GG) in the form of the prohibition of arbitrariness, overturned the judgment and remanded the case back to the FG. The BVerfG stated that the FG had not conducted the comprehensive assessment of all relevant circumstances required under the arm's length principle, but had instead focused solely on the fact that the companies had not concluded a written contract beforehand. The FG explicitly left open whether there were implied agreements regarding the toll manufacturing relationship and the compensation payment. The judgment did not remotely reflect a comprehensive evaluation of all circumstances related to the arm's length principle. Consequently, the FG fundamentally misunderstood the legal situation, rendering the judgment legally indefensible under any conceivable aspect, leading to the conclusion that it was based on extraneous considerations.
Practical Notes
The decision of the BVerfG clearly highlights that a significantly shortened "strict" interpretation of the arm's length principle, focusing solely on the existence of written contracts, is legally indefensible. This decision holds great practical significance, as such agreements between affiliated companies are a frequent point of contention in transfer pricing audits. The tax authorities often claim, as in the present case, that the absence of a written contract is inherently atypical for unrelated parties. The BVerfG's decision puts a stop to such arguments and aligns with the interpretation of the arm's length principle under Section 9 of the OECD Model Convention.
Conclusion
Taxpayers who need to defend the arm's length nature of orally concluded agreements should refer to the aforementioned decision and demand a comprehensive examination and overall assessment.
Regardless, it is advisable to establish written form for such agreements between related parties (toll or contract manufacturing relationships, transfer of functions including price adjustment clauses, service charges, sales commissions including year-end adjustments, loan or cash pooling agreements, etc.). These written agreements serve as strong indicators and significantly improve the evidential situation.
Our KPMG transfer pricing experts are available to assist you with any questions you may have.
Publication Date:
29 August 2025