A question often asked by foreign investors in US renewable energy projects is how much debt they can use to capitalize the US "blocker" corporation through which they invest.

The short answer is: "It is complicated." If you prefer not to read the detail, skip to the last sub-header "Pulling Everything Together."

Foreign companies and investment funds investing directly in US renewable energy projects almost always form an intermediate US entity to hold the investment. The US entity is a corporation for US tax purposes.

This is done so that the foreign company or investment fund will not be treated as engaged directly in a US business as that would require it to file US tax returns.

The problem with investing through a blocker corporation is the blocker corporation will be subject to US taxes at the full corporate tax rate on income from the project. Therefore, investors look for ways to "strip" earnings, which means withdrawing earnings from the blocker in a form that can be deducted by the blocker corporation. The most common way to do this is to lend part of the invested capital to the blocker so that earnings can be pulled out as deductible interest on the loan.

Most countries limit the extent to which earnings can be stripped through rules that either deny interest deductions or re-characterize purported loans as equity investments where the blocker has too small an equity layer.

The US had a bright-line test for determining when a blocker corporation was too thinly capitalized through 2017. However, starting in 2018, it dropped the bright-line test in favor of a cap on interest deductions.

Purported loans might still be re-characterized as equity investments, but the US tax authorities have struggled to draw clear lines. (For example, see "Tax rules could reclassify debt as equity" in the April 2016 NewsWire and "IRS revisits debt-equity and disguised sales" in the August 2017 NewsWire.)

Too little equity?

In an unleveraged blocker, the foreign investor contributes all the funds to the US corporation as equity.

In a leveraged blocker, the foreign investor would fund the blocker with a combination of debt and equity. The interest paid on the debt component is generally deductible and allows the blocker corporation to reduce its taxable income. The caveat is that for the interest to be deductible, the debt must be respected by the Internal Revenue Service. This typically requires the terms of the loan to be "arm's length" and the blocker corporation to be adequately capitalized.

Distinguishing debt from equity depends on consideration of the overall facts to determine the bona fides of the debt.

The US courts have identified 11 relevant factors. No one factor controls, so evaluating cases where the factors line up on both sides of the equity-debt divide requires judgment.

The factors are (1) whether the purported loan is called a loan, (2) whether it has a fixed maturity date and scheduled payments, (3) whether it bears a fixed rate of interest and requires interest payments, (4) the source of repayments, (5) the adequacy of capitalization, (6) the identity of interest between the creditor and the stockholder, (7) the security for the purported loan, (8) the corporation's ability to obtain financing on the same terms from third-party lenders, (9) the extent to which the purported loan is subordinated to the claims of outside creditors, (10) the extent to which the purported loan is used to acquire capital assets, and (11) the presence of a sinking fund to provide repayments.

What does it mean to be "adequately capitalized"? There is no bright-line test. However, the US Supreme Court suggested in a 1946 case, John Kelley Co. v. Commissioner, that a corporation is not too thinly capitalized if it has at least one part equity to four parts debt. However, this was in what lawyers call "dicta" because it was in a discussion in the opinion that was not central to an issue decided in the case. Therefore, it is not considered a binding precedent.

A low debt-equity ratio is not a guarantee against re-characterization of a purported loan as equity. The US Tax Court re-characterized debt as equity where there was a 1:1 debt-equity ratio because it determined there was never a real intention to repay the debt. The court said the fact that the shareholders in the case each held the purported debt instruments and shares in identical proportions suggested the "loans" were not real debt. There is little incentive in such a case to enforce the claim as a creditor if doing so would harm the parties' equity interests.

Different courts have taken different views about how much weight to give to the debt-equity ratio. One US appeals court declined to rule in a case involving shareholder debt, Rowan v. United States, that any certain level of debt-equity ratio is needed and said it is for Congress to do so if desired.

Another US appeals court, in a case called Bauer v. Commissioner, said the reason to look at a corporation's debt-equity ratio is it helps evaluate the risk that the purported loan will not be repaid. No real lender would make a loan that is unlikely to be repaid, and the interest rate usually varies depending on the riskiness of the loan. Therefore, in the view of this appeals court, the relevant inquiry is not a court-imposed capitalization standard, but whether a real lender would make such a loan.

The appeals court found helpful a letter from a Bank of America loan officer who said he had dealt with the company and was familiar with its financing during the years in question, and the bank would be willing to make loans equal to or greater than the amounts loaned by the shareholders.

Other courts have said the acceptable level of debt to equity depends on the industry involved and the character of the business being conducted. A company may be considered adequately capitalized by the standards of the particular industry.

Some courts have respected debt notwithstanding very thin capitalization. For example, one court accepted a debt-equity ratio as high as 692:1. However, a leveraged blocker is subject to greater scrutiny, especially where each shareholder holds both shares and debt in the same ratio and there is no independent business purpose for the blocker corporation, other than for reasons of tax planning.

Before 2018, there was a bright-line capitalization standard that had to be met in certain circumstances for interest to be deductible by the blocker. Section 163(j) of the US tax code had earnings-stripping rules that limited interest deductions for blockers using related-party debt if there was a debt-equity ratio above 1.5:1. The goal was to prevent the earnings of thinly capitalized corporations from being siphoned off, in the form of interest, by a foreign person or other person that was exempted from US taxes.

If the debt-equity ratio was greater than 1.5:1 at the end of a tax year, the corporation was prohibited from deducting interest paid to a shareholder or other related tax-exempt person during that year. Interest could not be deducted to the extent the total interest — including interest owed to unrelated persons — would exceed 50% of the corporation's "adjusted taxable income" (roughly speaking, its cash flow before deducting interest). Interest in excess of this 50% limit was called "excess interest expense." It could still be deducted if owed to an unrelated-person.

While the 1.5:1 debt-equity ratio is no longer in the US tax code, an investor could still view it as a "safe" ratio.

Limits on interest deductions

Since 2018, the US has moved to a cap on interest deductions that apply to all companies, not just where there may be cross-border earnings stripping. (For more detail, see "Cap on interest deductions explained" in the August 2020 NewsWire.)

The cap is 30% of "adjusted taxable income." Interest expense that cannot be deducted in a year because of the cap can be carried forward and deducted in later years. "Adjusted taxable income" is basically EBITDA: earnings before interest, taxes, depreciation and amortization. However, starting in 2022, it is calculated without subtracting depreciation and amortization, resulting in a lower limit and greater difficulty deducting interest.

Thus, the 30% cap creates a debt limitation that involves structuring considerations other than thin capitalization. Accordingly, the owner of a blocker corporation should first determine how much interest it expects to be able to deduct under the 30% cap and then back into how much debt that means. Thin capitalization principles should be applied once the optimal level of debt is determined.

When determining the optimal level of debt, foreign investors should also consider how much interest can be deducted without potentially subjecting the blocker to the US base erosion and anti-avoidance tax, better known as BEAT.

The BEAT also took effect in 2018 and targets earnings-stripping transactions between certain domestic corporations and related foreign persons. The BEAT functions as a minimum tax in that it only applies if the blocker corporation would owe more under the BEAT than it owes in regular tax liability. It also only applies to corporate groups with average annual gross receipts of more than $500 million. (For more details, see "How the US tax changes affect transactions" in the December 2017 NewsWire.)

While the underlying interest deduction remains intact, the BEAT, when it applies, requires payment of an additional tax at a 10% rate through 2025, increasing to 12.5% after that.

When applying the thin-capitalization analysis, the question arises whether project-level debt should be included. The reason for a thin-capitalization analysis is to determine if there is a likelihood of repayment and how the capital structure would influence an outside lender's risk assessment if this were not related-party debt.

Given this rationale, it makes sense to include the project-level debt since it directly affects the source of repayment for the blocker's debt. It is worth noting that former section 163(j) required that project-level debt be taken into account as part of the analysis. While the case law does not address this specific issue, the prudent approach would be to calculate the debt-equity ratio including the project-level debt.

Finally, foreign investors should consider the tax implications of receiving interest payments from the US blocker.

Interest payments are subject to a 30% withholding tax unless a "portfolio-interest exemption" applies or the foreign lender is eligible for a reduced rate or complete exemption under an income tax treaty with the United States.

For interest on the loan from the foreign investor to the blocker to qualify as "portfolio interest," the loan must be in registered form, meaning transferable by one holder to another only when the transferee is identified to the blocker. The interest payments cannot be contingent. The foreign investor cannot be a bank lending in the ordinary course of business. The foreign investor cannot own 10% or more of the voting stock of the blocker corporation directly or indirectly.

The last requirement makes reliance on the portfolio-interest exemption impossible in most situations, except where the investment is being made by a foreign investment fund in circumstances where the US allows looking through the foreign investment fund so that the fund investors are treated as owning shares of the blocker directly.

Pulling everything together

Summing up, what should a foreign investor in a renewable energy project learn from this discussion?

The first step is to determine the optimal level of debt taking into account the 30% cap on interest deductions and the BEAT, which is primarily a calculation exercise.

Then, thin-capitalization principles should be applied to determine whether the optimal level of debt is likely to be respected as debt for US tax purposes. There is no clear standard. The US no longer has earnings-stripping rules that impose a strict two-parts-equity-to-three-parts debt standard. Rather, common law principles control.

While not legally relevant, one could use the 1.5:1 debt-equity ratio from the old earnings-stripping rules as a "safe harbor," as it seems unlikely any court would view such a debt-equity ratio as "thin" capitalization. However, most people would view this as too conservative and a debt-equity ratio up to 4:1 seems to be a reasonable benchmark if one is looking for a clear-cut standard.

Based on the case law, it is also reasonable to conclude that there is no set debt-equity ratio required. Rather, it comes down ultimately to whether a third-party lender would be comfortable lending on the same terms. An evaluation from an independent rating agency or a bank letter would be helpful to have in the file.

The other take-away to remember is that thin capitalization is just one factor. It is crucial to follow all the formalities of a commercial debt instrument, including having a market interest rate and a fixed maturity date.