Written form for contracts between affiliated companies

In a ruling dated May 27, 2025 (2 BvR 172/24; published on July 7, 2025), the Federal Constitutional Court (BVerfG) overturned and referred back the ruling of the Thuringian Fiscal Court dated March 30, 2022 (1 K 68/17) due to a violation of Article 3 (1) of the German Basic Law (GG) in its form as a prohibition of arbitrariness. The subject of the constitutional complaint by the complainant (strategy sponsor) was the non-recognition of start-up losses of an affiliated sister company (contract manufacturer) as own operating expenses due to the lack of a corresponding written agreement between the two companies.

The complainant (GmbH & Co. KG) trades in sawn timber worldwide and is the strategic partner of the group of companies. It is responsible for purchasing the raw timber and carries out all centralized group functions as the administrative headquarters. A sister company (GmbH & Co. KG) acts as a contract manufacturer for the strategy owner and operates a sawmill for it. The strategic partner is also responsible for the planning and construction of the sawmills.

In 2005, the strategic partner planned and built a sawmill for the sister company. This resulted in planning errors and deficiencies in the implementation by the strategy leader, which led to extraordinary additional costs of more than EUR 4 million for the sister company. In 2008, the two affiliated companies reached a "damage compensation agreement" and the strategy leader paid the sister company compensation amounting to EUR 4 million. The strategy leader claimed this payment as its own operating expenses in its tax returns. There were no written contracts between the two affiliated companies regarding the transaction.

Initially, these operating expenses were taken into account by the tax office in accordance with the declaration and decided subject to review. As part of an external audit, the tax office then came to the conclusion that no written contract for work and services had been concluded for the planning and construction of the sawmill. It was therefore not comprehensible that the work had been carried out in a manner customary among third parties. As a result, the tax office denied the deduction of operating expenses and issued corresponding amendment notices.

The strategy leader lodged an appeal against this, arguing, among other things, that, as the strategy leader, it bore the production risks and had made the corresponding decisions, while the sister company was only active as a contract manufacturer and therefore did not have to bear any start-up losses. According to the "Administrative Principles on the Relocation of Functions" (BMF of October 13, 2010 - IV B 5 - S 1341/08/10003 BStBl 2010 I p. 774), such a contract manufacturer relationship could result from an actual practice. The objections were rejected as unfounded in an objection decision dated December 28, 2016. Without a written contract, the details of the agreement were not comprehensible. Such a verbal agreement contradicts the arm's length principle.

The appellant then brought an action before the Thuringia Fiscal Court (Finanzgericht Thüringen - FG) and now extended this to all start-up losses in the amount of EUR 7.5 million. At the hearing, the complainant presented evidence that it was solely responsible for the construction and maintenance of the sawmill, including the points that caused the start-up losses. In addition, the complainant submitted motions for evidence on the actual obligation to follow instructions and the lack of procurement risk on the part of the sister company. In its ruling dated March 30, 2022 (I K 68/17), the tax court dismissed the appeal and did not allow an appeal to the Federal Fiscal Court (BFH). The tax court stated that the business reason for the compensation payment had to be reviewed on the basis of the arm's length principle. This examination included the question of whether the agreement was effective under civil law, clear and unambiguous, whether its content corresponded to what was customary between unrelated third parties and whether it was actually carried out (reference to BFH, judgment of July 29, 2015 - IV R 16/12 - BFH/NV 2015, p. 1572 - para. 17). The verbal agreement would not meet these requirements. The actual implementation of a contract manufacturer relationship is therefore no longer relevant.

The complainant lodged an appeal against this decision with the BFH and argued, among other things, that there was a divergence in case law (Section 115 (2) no. 2 case 2 FGO). The necessary examination of the requirements of the arm's length principle had not been carried out. Instead, only the absence of a written agreement was taken into account. This was contrary to the case law of the BFH (judgment of January 24, 1990 - I R 157/86 - BStBl. II 1990, p. 645 and of May 12, 2016 - IV R 27/13 - BFH/NV 2016, p. 1559) and the BVerfG (decision of the 1st Chamber of the 2nd Senate of November 7, 1995 - 2 BvR 80/90). The BFH dismissed the appeal against denial of leave to appeal as unfounded in its decision dated March 8, 2023 (IV B 35/22). The BFH also rejected an appeal for a hearing in its ruling dated May 25, 2023 (IV S 10/23).

In a decision dated May 27, 2025 (2 BvR 172/24), the BVerfG ruled that the judgment of the tax court violated the general principle of equality (Article 3 (1) GG) in the form of the prohibition of arbitrariness. It therefore set aside the judgment of the tax court and referred the case back to the tax court. The BVerfG stated that the tax court had not carried out the overall assessment of all relevant circumstances required in the context of the arm's length comparison, but had instead focused solely on the fact that the companies had not concluded a written contract in advance. The tax court had explicitly left open whether there had been implied agreements regarding the contract manufacturer relationship and the compensation payment. An overall assessment of all the circumstances of the arm's length comparison could not be inferred from the judgment. Accordingly, the tax court had blatantly misjudged the legal situation, so that the judgment was not legally justifiable under any conceivable aspect and the conclusion that it was based on irrelevant considerations was forced upon it.

The decision of the Federal Constitutional Court makes it clear with gratifying clarity that a highly abbreviated "strict" interpretation of the arm's length principle, which is based purely on the existence of written contracts, is legally unjustifiable. The decision is of great importance in practice, as such agreements between affiliated companies are a regular point of contention in the context of transfer pricing audits. The tax authorities often claim, as in this case, that the absence of a written contract is per se unusual for third parties. The decision of the Federal Constitutional Court puts a stop to this type of argumentation and, in this respect, is in line with the interpretation of the arm's length principle of Article 9 of the OECD Model Tax Convention.

Taxpayers who have to defend the arm's length nature of verbally concluded contracts should refer to the above-mentioned decision and request a full examination and overall assessment.

Irrespective of this, it is nevertheless advisable to conclude written contracts for such agreements between affiliated companies (wage or contract manufacturer relationship, transfer of functions including price adjustment clauses, service charges, sales remuneration including year-end adjustments, loan or cash pooling agreements, etc.). These have a strong indicative function and significantly improve the evidence base.

Our KPMG transfer pricing experts will be happy to answer any questions you may have.