The requirement for written form as the sole precondition for deducting operating expenses is arbitrary

Section 4 (4) of the German Income Tax Act (Einkommensteuergesetz; EStG) defines business expenses as all expenses incurred by the business in cash or cash equivalents. In its decision of May 27, 2025 (case no. 2 BvR 172/24), the Federal Constitutional Court (Bundesverfassungsgericht, BVerfG) clarified whether and to what extent compliance with the written form requirement can be used as a criterion for determining the business-related nature of expenses within the framework of the arm's length comparison to be made in this context.

The company, which was strategically active in a group of companies involved in wood processing and trading, had built a sawmill for a sister partnership with identical shareholdings. Due to poor planning and inadequate implementation, the latter suffered damages amounting to approximately EUR 4 million. These damages were compensated by the strategically active company. There were no written agreements regarding the planning and construction of the sawmill or the agreement on compensation for damages. Since it was therefore not possible to verify that the content and implementation of the transactions were as usual between unrelated parties, the tax office refused to allow the compensation for damages to be deducted as operating expenses. The tax court (FG) called upon to rule on this matter confirmed this rejection, basing its decision exclusively on the absence of written contracts: Third parties would have concluded written contracts from the outset – in the amount of millions – both for the construction of the sawmill and for the associated ongoing operational use (in this case by means of contract manufacturing relationships), from which at least the essential rights and obligations of the contracting parties, including the assumption of the essential risks, would have been apparent. Further evidence was not admitted.

The BVerfG vehemently opposed this approach. Although the interpretation and application of a law to individual cases is a matter for the competent courts and is therefore generally not subject to review by the BVerfG. However, in rare exceptional cases, constitutional court intervention may be considered on the grounds of a violation of the principle of equality (Art. 3(1) GG) in its meaning as a prohibition of arbitrariness. This was the assumption in this case.

It considered the decision of the FG to be legally untenable under any conceivable circumstances. This was because the FG had made compliance with the written form a constituent element of § 4 (4) EStG in the context of the arm's length comparison to be made, which contradicts the case law of the BVerfG in a manner that is simply untenable.

The BVerfG further found that the FG had not carried out the overall assessment of all relevant circumstances required in the context of the arm's length principle but had based its decision solely on the fact that the companies involved had not entered into any written agreements in advance. In doing so, it had not considered the complete absence of agreements (e.g., verbal agreements) to be decisive, but rather the failure to conclude written contracts. It had also expressly left open the question of whether any implied agreements on contract manufacturing or agreements on the payment of damages had been concluded. On the other hand, it had always referred to written contracts or written agreements and described the requirement for written contracts that may arise from the arm's length principle as “not merely a superfluous formality.”

The FG had therefore not dealt with the extensive supreme court case law on the question of the required overall assessment of all circumstances in the context of the arm's length principle, but had merely cited a ruling by the German Federal Fiscal Court from 2015 (case no. IV R 16/12), which also provides for the obligation to make an overall assessment based on the established facts. However, the BVerfG could not even begin to infer this from the present ruling of the FG and therefore referred the case back to the FG for a new decision after the required overall assessment (if necessary, after taking evidence).

 

Notice: 

In cases with a foreign connection, case law had already ruled years ago that Art. 9 OECD-MA has a blocking effect on corrections based on domestic legislation insofar as these corrections are based on purely formal objections, specifically the lack of written form. As a result, the tax authorities amended the corporate income tax guidelines for cases with a foreign connection.

From a procedural law perspective, it is interesting to note that it was the BVerfG that overturned the FG ruling and referred the matter back to the FG, and not the German Federal Fiscal Court. The latter had previously rejected the appeal against the inadmissible revision.