The transaction concerned activities within the A Group in the 2008 tax year, involving two sister partnerships with identical ownership and management. T KG acted as the strategic head office of the group and was responsible for planning and constructing a new production plant operated by its sister partnership, C KG. No written contract governed the construction of the plant. Following significant planning errors and implementation deficiencies, the parties concluded a compensation agreement in October 2008 under which T KG agreed to bear substantial start-up losses and pay damages to C KG. T KG treated both the compensation payment and the assumed start-up losses as tax deductible operating expenses.
The tax authorities refused to recognise the deduction of the compensation payment and the start-up losses. They held that, between related parties, such expenses could only be deductible if based on clear, civil law valid, arm’s length agreements comparable to those concluded between independent third parties. In their view, neither a contract for work nor a contract manufacturing agreement had been properly agreed or documented. The absence of contemporaneous written contracts meant that the alleged obligations could not be accepted as business related for tax purposes.
T KG argued that a contract manufacturing relationship existed in substance and that, under arm’s length principles, start-up losses at the manufacturing entity should be borne by the principal. It relied on German administrative guidance on transfers of functions, claiming that a contract manufacturing relationship could be inferred from actual conduct and economic reality, even without written agreements. T KG also argued that denying deduction would lead to unequal treatment between domestic and cross border situations.
Judgment
The Finance Court dismissed the action and upheld the tax authorities’ position. The court held that arm’s length testing between related parties requires clear and unambiguous agreements that are customary between unrelated parties and actually implemented, and that these requirements were not met. The German administrative guidance on transfers of functions was found to have no binding effect and no applicability to purely domestic situations. The court concluded that neither the compensation payment nor the assumption of start-up losses was deductible.
The judgment has later been overturned by the Federal Constitutional Court
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