Arm's length principle for tax deduction: Federal Constitutional Court overturns contractual requirement
- Patricia Lederer
- Aug 11
- 3 min read
Company wins in “David vs. Goliath” case against the tax office
Frankfurt am Main
August 11, 2025
The Federal Constitutional Court rules in favor of taxpayers. With the decision published on July 7 , 2025 2 BvR 172/24, the Federal Constitutional Court ruled: The absence of a written contract or invoice does not automatically lead to the loss of the business expense deduction. The ruling on arm's length principle for tax deduction currently provides clarity in tax law.
What happened?
A sawmill in Thuringia, organized into two closely affiliated companies (one purchasing timber, the other processing it), built a new mill. Construction resulted in over €4 million in additional costs , which were paid by one company to the other – without a written contract or invoice .
The tax office initially accepted these expenses, but later canceled them after an audit, citing the lack of tax deduction according to the arm's length principles : In the case of related parties, everything must be handled as is customary between unrelated third parties - and in the auditors' opinion, this necessarily includes contracts and invoices.
Walk through the instances
Thuringian Finance Court : confirmed the view of the tax office
Federal Finance Court (BFH) : also rejects the business expense deduction
Federal Constitutional Court : Acceptance of the constitutional complaint and fundamental decision in favor of the company
The decision of the Federal Constitutional Court
The Karlsruhe judges first examined Section 4 Paragraph 4 of the Income Tax Act (EStG) , which applies to all taxpayers—including through the Corporate Tax Act for capital companies. It clearly states:
“Operating expenses are those expenses incurred by the business.”
The law does not stipulate a requirement for written form or an invoice . Nor does the established case law on arm's length principle tax deduction provide for such a rigid formal requirement .
The core statement of the Federal Constitutional Court: The Finance Court had elevated the written form to an additional element of the offense that is not contained in the law – and thus violated the case law of the Federal Constitutional Court in a "completely untenable manner."
Significance for companies and self-employed people
The ruling strengthens the case for taxpayers whose business expenses are rejected by the tax office on purely formal grounds. Key points:
Costs must be operationally incurred and verifiably incurred
Written contracts or invoices can help, but are not a mandatory legal requirement
The arm’s length principle remains – but without excessive formal requirements
Practical tip from TaxPro
Anyone who receives mail from the tax office in which expenses are canceled due to allegedly missing formal requirements should:
File an objection – in due form and within the deadline
Submit receipts and proof of payment
Check the information in the notice – do they really fit the facts?
Use judgment 2 BvR 172/24 as an argumentation aid
Conclusion
The Federal Constitutional Court's ruling sends an important message: substance over formalities . If business expenses have actually been incurred and paid, they cannot be disallowed solely due to missing contract or invoice documents. This strengthens entrepreneurs and self-employed individuals in disputes with the tax office – especially during audits.
Source: Federal Constitutional Court, decision of 27 May 2025 – 2 BvR 172/24 (published on 7 July 2025)
Even more information on this topic can be found in the latest YouTube video on the TaxPro channel. It's worth checking out!
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