Tax Credit Bonds: A Brief Explanation

^Pr^ep^ar^{ed f}^o^r^M^e^m^b^ers^an^d^Com^mⁱ^t^t^ees^of^C^ong^r^e^ss

Tax Credit Bonds (TCBs) are a type of bond that offers the holder a federal tax credit instead of
interest. This report explains the tax credit mechanism and describes the market for the bonds.
Currently, there are four types of TCBs: qualified zone academy bonds (QZABs), clean
renewable energy bonds (CREBs), gulf tax credit bonds (GTCBs), and forestry conservation
bonds (FCBs). QZABs, which were the first tax credit bonds, were introduced as part of the
Taxpayer Relief Act of 1997 (P.L. 105-34) and were first available in 1998. CREBs were created
by the Energy Policy Act of 2005 (P.L. 109-58) and GTCBs by the Gulf Opportunity Zone Act of

2005 (P.L. 109-135). FCBs were created by the Food, Conservation, and Energy Act of 2008 (P.L.

110-234).

Each TCB is designated for a specific purpose or type of project. Issuers of QZABs are required
to use the proceeds to finance public school partnership programs in economically distressed
areas. CREBs are designated for clean renewable energy projects. GTCB proceeds are for the
refinancing of outstanding government debt in Gulf Coast regions affected by Hurricane Katrina.
GTCBs could only be issued in 2006. FCBs are intended to help non-profits or government
entities purchase then conserve forest land.
All of the TCBs are temporary tax provisions. In December 2006, Congress extended the QZAB ^th
program, with modifications, for 2006 and 2007. Several bills have been introduced in the 110
Congress that would extend, expand, modify, or create new tax credit bonds. S. 2886 would
extend QZABs two years, through 2009, and would add $400 million in capacity to the CREB
program. H.R. 6049, which was approved by the House on May 21, 2008, would extend QZABs
one year, expand CREBs, and create a new type of tax credit bond for energy conservation.
Similarly, S. 3335 would extend QZABs one year, authorize $2 billion of new CREBs, and create
energy conservation TCBs.
This report will be updated as legislative events warrant.

Introduc tion ..................................................................................................................................... 1
The Details of Tax Credit Bonds.....................................................................................................2
QZA Bs .......................................................................................................................... ............ 2
Qualified Zone Academy....................................................................................................2
Annual QZAB Limit...........................................................................................................2
Term of QZAB Debt...........................................................................................................3
The QZAB Tax Credit Rate................................................................................................3
Arbitrage Rules...................................................................................................................3
CREBs, GTCBs, and FCBs.......................................................................................................3
Comparison of TCBs.................................................................................................................4
Investing in Tax Credit Bonds vs. Other Bonds........................................................................6
The Bond Market and TCBs...............................................................................................6
Table 1. Comparison of Tax Credit Bonds......................................................................................5
Author Contact Information............................................................................................................7

Almost all state and local governments sell bonds to finance public projects and certain qualified
private activities. Most of the bonds issued are tax-exempt bonds because the interest payments
are not included in the bondholder’s (purchaser’s) federal taxable income. Naturally, interest
payments not included in taxable income escape federal income taxation. In contrast, interest
payments from other types of bonds, such as corporate bonds, are included in a bondholder’s
taxable income. Because of the difference in taxability, state and local government tax-exempt ¹
(municipal) bonds offer a lower pre-tax interest rate than corporate bonds. The federal
government is providing a subsidy for projects that use tax-exempt financing of approximately

20% to 30% of the interest cost on the bonds. For example, on August 7, 2008, the average high-

grade taxable corporate bond rate was 5.70%, and the average high-grade municipal bond rate ²
was 4.75%. The municipal bond rate is about five-sixths of the taxable bond rate, a considerable
subsidy for the bond issuer.
In contrast, tax credit bonds (TCBs) allow the holder to claim a federal tax credit equal to a
percentage of the bond’s par value (face value) for a limited number of years. This tax credit
percentage is set at the current yield on taxable corporate bonds. Thus, TCBs deliver a larger
federal subsidy to the issuer than do municipal bonds. The subsidy to the issuer is the full 5.70% ³
instead of the difference between the taxable rate and the lower tax-exempt rate of 4.75%. With
tax credit bonds, the issuer does not pay any interest.
Currently, there are four types of tax credit bonds with varied authorization periods: qualified
zone academy bonds (QZABs), clean renewable energy bonds (CREBs), gulf tax credit bonds
(GTCBs), and forestry conservation bonds (FCBs). QZABs, originally enacted as part of the
Taxpayer Relief Act of 1997 (TRA 1997; P.L. 105-34), are not permanent though Congress has ^th
extended the program several times. In the 107 Congress, the Job Creation and Worker ^th
Assistance Act of 2002 (P.L. 107-147) extended QZABs through 2003. In the 108 Congress, P.L. ^th

108-311 extended QZABs through 2005. In the 109 Congress, the Tax Relief and Health Care ^th

Act of 2006 (TRHCA; P.L. 109-432) extended QZABs through 2007. In the 110 Congress, S.
2886 would extend QZABs through 2009. And, H.R. 6049, which was approved by the House on
May 21, 2008, would extend QZABs one year, expand CREBs, and create a new type of tax
credit bond for energy conservation. QZABs allow qualified issuers to carry forward unused
capacity for up to two years. Thus, QZABs could be issued beyond 2007 if unused capacity were
carried forward by qualified issuers.
CREBs were created by the Energy Policy Act of 2005 (P.L. 109-58) and the GTCBs by the Gulf
Opportunity Zone Act of 2005 (P.L. 109-135). The TRHCA increased the volume cap for CREBs
from $800 million to $1.2 billion and extended the authority to issue CREBs from December 31, ^th
2007, to December 31, 2008. S. 2886 in the 110 Congress would add $400 million to CREB
volume. Authorization to issue GTCBs expired on January 1, 2007. FCBs were created by the
Food, Conservation, and Energy Act of 2008 (P.L. 110-234).

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The first section of this report examines the mechanics of TCBs in more detail. The second
section of this report analyzes the market for TCBs relative to municipal and corporate bonds.

A TCB allows the bondholder to claim a tax credit equal to a specified credit rate as determined
by the Secretary of the Treasury. The rate of credit is intended to be set such that the bonds need
not be sold at a discount (for a price less than the face value) or with interest cost to the issuer.
The government entity selling the bond is obligated to repay only the principal of the bond. The
federal government makes “payments” to the bondholder through the tax credits. The tax credits
delivered through the bonds are unlike typical tax credits because the credit is included in taxable
income as if it were interest income. The tax credit bond rate is set with the intent of
compensating for the taxability. The structure of each TCB is explained briefly in this section.
The first TCBs were introduced as a part of the Qualified Zone Academy Bond (QZAB) program
in the Taxpayer Relief Act of 1997. Under this program, individual public schools, through their
participating state and local governments, use the bond proceeds for school renovation (not
including new construction), equipment, teacher training, and course materials. To qualify for the
program, the school must also be a “Qualified Zone Academy.”
A “Qualified Zone Academy” is any public school (or program within a public school) that
provides and develops educational programs below the postsecondary level if
^s^u^c^h^pu^blⁱ^c^s^c^h^ool^{or pr}^og^ra^m^(as^t^h^{e cas}^e^m^a^y^{be) i}^s^desⁱ^gⁿ^e^{d i}ⁿ^cooperatⁱ^oⁿ^wⁱ^t^h^b^u^sⁱⁿ^e^ss
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The academy must also be located in an empowerment zone or enterprise community.
Alternatively, the academy also qualifies if it is reasonably expected that at least 35% of the
students qualify for the free or reduced price school lunch program. At least 95% of the bond
proceeds must be used for rehabilitating or repairing public school facilities, providing
equipment, developing course materials, or training teachers and other school personnel.
The limit for new QZAB debt is $400 million annually from 1998 through 2007. The limit is
allocated to the states based upon their portion of the population below the poverty line. States are
responsible for the allocation of the available credit to the local governments or qualified zone
academies. Unused credit capacity can be carried forward for up to two years.

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The maximum term (the number of years for which the credit will be paid) “shall be the term
which the Secretary estimates will result in the present value of the obligation to repay the ⁵
principal on the bond being equal to 50% of the face amount of the bond.” Specifically, the
maximum term of the bonds is determined by the prevailing interest rate for municipal debt with
a maturity of greater than 10 years. The maximum term on QZABs issued on August 13, 2008,
was set at 14 years.
Since July 1999, the Secretary of the Treasury establishes a national credit rate that is generally
intended to allow issuers of QZABs to sell their bonds at par (face value) without additional
interest expense. The credit rate published (by the U.S. Bureau for Public Debt) on the issue sale
date is the bondholder’s annual rate of credit. For example, the annual tax credit rate was 5.89%
on August 13, 2008. The bonds sold on that day would allow the taxpayer to claim a federal tax
credit in one year equal to 5.89% multiplied by the face value of the bond. Thus, a $100,000 bond
issued on August 13, 2008, would yield a tax credit of $5,890 for the bondholder one year after
the original issue and each following anniversary for the term of the bond. However, unlike
interest on municipal bonds, which does not create a taxable income stream, the credit amount is ⁶
included in the bond holder’s gross income. The credit is limited to the bondholder’s current tax
liability; it is “non-refundable.”
Before the 2006 extension of the QZAB program, QZABs were not subject to the same arbitrage
rules as traditional tax-exempt bonds. The TRHCA Act of 2006 requires that QZABs follow the
same arbitrage limits as traditional tax-exempt bonds. Generally, issuers of QZABs must ensure
that 95% of the proceeds are spent within five years of issuance.
Clean renewable energy bonds (CREBs) are available to electric cooperatives to finance qualified
energy production projects which include (1) wind facilities, (2) closed-loop bio-mass facilities,
(3) open-loop bio-mass facilities, (4) geothermal or solar energy facilities, (5) small irrigation
power facilities, (6) landfill gas facilities, (7) trash combustion facilities, (8) refined coal
production facilities, and (9) certain hydropower facilities. The national limit on the bonds, which
can be issued through 2008, is $1.2 billion of which a maximum of $750 million can be granted
to governmental bodies. The term and credit rate for CREBs are determined in the same manner
as QZABs. The CREB credit is split into four quarterly payments in contrast to the annual QZAB
credit. CREBs are also subject to the arbitrage rules that require the issuer to spend 95% of the
proceeds within five years of issuance.

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The third type of TCBs are gulf tax credit bonds (GTCBs). The authority to issue these bonds
expired on January 1, 2007. GTCBs could have been issued by the states of Louisiana,
Mississippi, and Alabama to (1) refund bonds outstanding on August 28, 2005, that were issued
by the designated states or (2) to make a loan to a jurisdiction within the designated states to
cover the principal, interest, or premium of debt issued by that jurisdiction. Unlike the other two
types of bonds, the maximum maturity was capped at two years. The credit rate for the two-year
bonds was set in the same manner as the other TCBs. Louisiana could issue up to $200 million,
Mississippi $100 million, and Alabama $50 million.
Forestry Conservation Bonds (FCBs) are limited to $500 million to be allocated before May 22,
2010 (24 months after enactment of P.L. 110-234). Once the bonds are issued, the proceeds must
be spent within three years. A unique feature of FCBs is the allowance for an allocation amount to
be used to offset any taxes due the federal government. Any allocation amount used to settle
outstanding federal tax debts cannot be used for bond issuance. A qualified issuer is a “State or ⁷
any political subdivision or instrumentality thereof or a 501(c)(3) organization.” For purposes of ⁸
the FCB program, a qualified forestry conservation purpose must meet the following criteria:
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^Un^ited^State^s^Fi^sh^aⁿ^d^W^ild^lif^{e Ser}^v^ice.
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The four TCBs created by Congress have distinctive characteristics that differentiate the bonds
from each other. As policy makers consider using new TCBs, investors (and other market
participants) may request that TCB mechanics become more standardized. As Table 1 exhibits,
TCBs have generally the same structure, though differences increase the cost to taxpayers who
invest in the bonds. For example, QZABs pay credits once per year and the credits are not
strippable. Whereas FCBs, the newest TCB, offer credits quarterly and allow investors to strip the
credits from the principal and sell them.

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Table 1. Comparison of Tax Credit Bonds
^Bond^{QZABs CREBs}^GCTCBs^FCBs
^Feature
^Purpose^{School renovation}^Investme^{nt in}^{Post-disaster loca}^l^{Forest conservation}
^{renewable e}^nergy^government^debt
^assistance
^{I.R.C. secti}^on^{sec. 13}⁹⁷^E^{sec. 54}^{sec. 14}⁰⁰^N^{sec. 54A &}^54B
^{and Public Law}^{P.L. 105-3}⁴^{P.L. 109-5}⁸^{P.L. 109-1}³⁵^{P.L. 110-2}³⁴
^{Authorization}^{expired 1}^2/3^1/2⁰⁰⁷^expires^12/^31/²⁰⁰⁸^{expired 1}^2/3^1/2⁰⁰⁶^expires^5/2^2/2⁰¹⁰
^status
^{Credit rate}^{Set to insure no cost}^{Set to insure no cost}^{Set to insure no}^{Set to insure no cost}
^{or discount to issuer}^{or discount to issuer}^{cost or discount to}^{or discount to issuer}
^{at a rate eq}^{uivalent to}^{at a rate eq}^{uivalent to}^{issuer at a ra}^te^{at a rate eq}^{uivalent to}
^{a taxable 1}^0-yr^bond^{a taxable1}^0-yr^bond^a^{equivalent to a}^a^{a taxable1}^0-yr^bond^a
^taxable1^{0-yr bo}^nd
^Credit^{annual quarte}^rly^quarte^rly^quarte^rly
^payment
^Credit^{no no}^no^yes
^strippable
^Term^b^log(2)/l^og(1+r)^log(2)/l^og(1+r)²^years^log(2)/l^og(1+r)
^{Issuer government}^entity,^{an electric coop, a}^{Alabama, Louisiana,}^{state or political}
^{e.g., LEA}^{coop that has}^made^{and Mississippi}^{subdivision thereof,}
^{loans to 100 or}^more^501(c)(3)
^{coops, government}
^entity
^{Investor or}^{bank, insu}^rance^{co., or}^{no restrictions}^{no restrictions}^{no restrictions}
^taxpaye^r^{corporation in the}
^busines^{s of lending}
^money
^Partners^hip^{10% of iss}^{ue m}^ust^be^{n/a One-to-one}^match^{None thoug}^h^50%^of
^{matched by}^private^{with state fu}^{nds for}^{forest land p}^urcha^sed
^busines^{s par}^tner^{same p}^urpose^{with bonds m}^{ust b}^e
^transfe^{rred to the}
^USFS
^Authorized^$40^{0 million annually}^{$1.2 billi}^on^through^$35^{0 million}^$50^{0 million}
^amount¹⁹⁹^{7 to 2}⁰⁰⁷²⁰⁰⁸^through²⁰⁰⁶
^Allocat^ion^{State-by-state based}^{Projects the Secretary}^{AL: $50}^milli^on^{Projects the Secretary}
^process^{on state’s portion of}^determines^{LA: $20}^{0 million}^determines
^{total US population}^approp^riate^{MS: $10}^{0 million}^approp^riate^c
^{below poverty line}
^Carryover^{Up to two years}^n/a^n/a^n/a
^{Registration/}^No^{yes; report as}^yes^{no; report as}
^reporting^{under s}^{ec. 14}^9(e)^{under s}^{ec. 14}^9(e)
^a.^{In contra}^{st to QZABs, CREBs, GTCBs, and FCBs all}^{ow the Secretary’s designee to estimate the a}^p^propriate
^{credit rate.}
^b.^{For the term}^{calculations, “r” is the average a}ⁿⁿ^{ual interest}^{rate of}^tax-exem^{pt debt}^{having a t}^{erm o}^f¹⁰
^{years or more.}
^c.^{Up to 50}^{% of FCB allocation can be used to satisfy}^outstanding^{federal tax debts.}

The credit rate for TCBs is set higher than the municipal bond rate to compensate for the credit’s
taxability. Generally, to attract investors, the credit rate should yield a return greater than the
prevailing municipal bond rate and at least equal to the after-tax rate for corporate bonds of
similar maturity and risk.
Consider the following example where we assume an average 4.75% interest rate on municipal
debt. Investors in the 15% income tax bracket would need a credit rate of at least 5.59% (4.75%
divided by (1 - 0.15) is 5.59%) to choose TCBs over municipal bonds. Investors in the 35%
bracket would require a credit rate on TCBs of 7.31% (4.75% divided by (1 - 0.35) is 7.31%).
Generally, the TCB credit rate would have to exceed the return on municipal bonds and the after-
tax return on corporate bonds of like term to maturity, given an investor’s tax bracket.
The summary below describes how a potential bond investor would evaluate the attractiveness of
a tax credit bond relative to two other bond investments. The choice between TCB and traditional
tax-exempt municipal bonds is dependent upon the bondholder’s tax rate. When compared to
municipal bonds, bondholders in the highest tax bracket find the tax credit less attractive than
those in the lower brackets. However, the tax credit is fixed at the same rate for all buyers.
^{Evaluating a Tax Credit Bon}^{d Investment}
^t⁼^{income tax rate of}^{bond holder}
^r^TCB⁼^pre-tax^{rate of TCB credit}
^r^muni⁼^{prevailing interest rat}^{e on hig}^{h gr}^{ade tax-exem}^{pt mu}^{nicipal bonds}
^r^corp⁼^{prevailing interest rat}^{e on cor}^{porate bonds}
^Purchase^{a TCB if:}
^r^TCB^>^r^muni^/(1-t)
^or
^r^TCB^>^r^corp
^{The TCB tax credit rate m}^ust^be^{greater tha}^{n (a) alternative ta}^x-exempt^mu^{nicipal bond interest}^ra^{te divided}
^{by one min}^{us t}^{he income ta}^{x rat}^{e, or (b) the p}^{revailing corporate}^{bond rate.}
The choice between a tax credit bond and a taxable corporate bond is not as dependent upon the
bondholder’s tax bracket. At comparable levels of default risk, TCBs and corporate bonds are
equally attractive to purchasers that anticipate tax liability. However, a corporation without tax
liability that holds a tax credit bond would not be allowed to claim a credit for future tax liability.
For these investors, this risk may not be sufficiently covered by the potential for a future tax
credit.
There are two agents in the market for bonds: the bond seller and the bond buyer. The price and
yield of bonds is determined by the interaction of supply (bond sellers) and demand (bond
buyers). Bond prices and interest rates determine the yield or rate of return on bonds. In all cases,
the yield on bonds moves in the opposite direction from bond prices. If investors believe the

expected yield on bonds is greater than what the current prices and interest rates reflect, bond
prices will rise, lowering the yield. Alternatively, if investors believe the expected yield on bonds
is too low, bond prices will fall, raising the yield.
The market for TCBs is not like the market for traditional tax-exempt bonds and corporate bonds.
In contrast to traditional bonds, which are available to almost all investors, QZAB credit is only
available to certain financial institutions. The limited number of potential buyers would likely put
downward pressure on the demand for QZABs relative to other TCBs. In contrast, CREB, GTCB,
and FCB credits are available to any taxpayer.
Also, the federal credit from TCBs cannot be adjusted to reflect the perceived riskiness of
individual bond issuers. In traditional bond markets, issuers with strong credit ratings can offer
bonds at lower interest rates whereas issuers with weak credit ratings typically offer higher
interest rates to compensate for the higher default risk. TCB issuers with relatively weak credit
ratings can and have offered supplemental interest payments, original issue discounts, or bond
insurance to investors to compensate for the greater risk. Some issuers and observers have noted
that these additional payments seem contrary to the intent of Congress to have the Secretary of
the Treasury set the rate such that TCBs can be issued without discount and without interest cost
to the issuer.
The relatively small annual TCB volume capacity—$400 million of QZABs per annum; $1.2
billion total of CREBs; $350 million of GTCBs; and $500 million of FCBs compared to $430
billion (in 2007) of municipal bonds—also limits the market attractiveness of TCBs. Investors ⁹
generally prefer deep secondary markets for assets. However, the unique nature of the TCB tax
credit and the limited volume make it difficult for investors to justify devoting resources
necessary to properly evaluate TCBs.
Even with potential weakness in the market for TCBs generally, Congress has extended QZABs ¹⁰
several times and added three new types of TCBs since QZABs were first issued in 1998.
Analysts in the bond community generally agree that the tax credit mechanism may need further
adjustments before TCBs are widely accepted by investors as alternatives to municipal bonds or
taxable bonds. To date, no comprehensive study of the TCB programs has been undertaken.

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^inv^e^s^t^or^s^,^s^e^e^T^hor^ntoⁿ^Ma^the^s^on^{, “}^Q^ua^lif^ie^{d Zone}^A^c^a^d^em^y^B^ond^I^s^s^u^aⁿ^c^e^a^{nd I}ⁿ^v^e^s^t^m^e^{nt: Ev}^ideⁿ^c^e^f^r^o^m²⁰⁰⁴
^For^m⁸⁸⁶^{0 D}^a^ta^,”^St^atistic^{s o}^f^In^c^o^me^Bulle^tiⁿ^{, U}^.^S^.^D^e^pa^r^t^m^e^{nt o}^f^T^r^e^a^s^ur^y^,^Iⁿ^te^rⁿ^a^l^R^e^v^e^nue^Se^r^v^ic^e^,^Sprⁱ^ng²⁰⁰⁷^.
¹⁰^P^.^L^.¹⁰^6-¹⁷⁰^,^eⁿ^a^c^t^e^d^{on D}^e^c^.¹⁷^{, 1}⁹⁹⁹^{, e}^x^teⁿ^d^e^d^t^h^e^Q^Z^A^B^pr^og^r^a^m^tw^o^y^e^a^r^s^,^thr^oug^h²⁰⁰¹^.^P.L^.¹⁰^7-¹⁴^{7, (}^M^a^r^.
^{9, 2}⁰⁰²⁾^,^e^x^te^nde^{d t}^h^e^pr^og^r^a^m^anot^he^r^tw^{o y}^e^a^r^s^,^thr^oug^h²⁰⁰³^.^P.L^.^108-³¹^{1, (}^O^c^t^.^4,²⁰⁰⁴⁾^,^e^x^teⁿ^d^e^d^t^h^e^pr^og^r^a^m
^thr^o^ug^{h 2}⁰⁰⁵^.^P.L^.¹^09-⁴³^{2, (}^D^e^c^.²⁰^{, 2}⁰⁰⁶⁾^,^e^x^teⁿ^d^e^d^t^h^e^pr^og^r^a^m^thr^o^ug^h²⁰^07.