Tax Credit Bonds

Tax Credit Bonds (TCBs) are a type of bond in which the holder receives a federal tax credit rather than interest. This study describes the bond market as well as the tax credit system.

Qualified zone academy bonds (QZABs), clean renewable energy bonds (CREBs), Gulf tax credit bonds (GTCBs), and forestry conservation bonds (FCBs) are the four forms of TCBs now available.

Understanding Tax Credit Bonds

Almost every state and local government issues bonds to fund public projects as well as certain qualified private enterprises. Because interest payments are not included in the bondholder's (purchaser's) federal taxable income, the majority of bonds issued are tax-exempt. Naturally, interest payments that are not included in taxable income are not subject to federal income taxation.

In contrast, interest payments from other forms of bonds, such as corporate bonds, are taxable income to the bondholder. State and local government tax-exempt (municipal) bonds give a lower pre-tax interest rate than corporate bonds due to the difference in taxability.The federal government is giving a subsidy of around 20% to 30% of the interest cost on the bonds for projects that employ tax-exempt financing.

Mechanics of Tax Credit Bonds

TCBs provide a tax credit that can be used to lower federal income tax liability immediately. The credit available from a TCB is determined by the bond principal and interest rate. The process of determining the credit rate varies depending on the type of TCB:

Investor credit tax credit bonds

The credit rate for investor and issuer credit TCBs is determined by the Secretary of the Treasury's national credit rate. This national credit rate is intended to allow TCB issuers to sell their bonds at par (face value) without incurring additional interest costs.

The rate calculation is based on its [the Treasury Department's] estimate of the yields on outstanding bonds from market sectors selected by the Treasury Department at its discretion that have an investment grade rating between A and BBB for bonds of a similar maturity for the business day immediately preceding the sale date of the tax credit bonds for the business day immediately preceding the sale date of the tax credit bonds.

The bondholder's yearly rate of credit is the credit rate published (by the United States Bureau of the Fiscal Service) on the issue sale date.

The federal tax code governs the relationship between the national credit rate set by the Treasury and the final credit rate applied to a bond offering, and it varies depending on the kind of investor and issuer TCB. The credit on 100% credit TCBs gives a benefit equal to the product of the national credit rate and the bond principal.

Issuer direct payment tax credit bonds

Unlike investor credit TCBs, the benefit claimed for issuer direct payment TCBs is determined by the interest rate agreed upon by the buyer and issuer of the bond, not by the Secretary of the Treasury. The issuer and investor reach an agreement on terms either through a competitive bid procedure or through a negotiated transaction.

The relationship between the final credit rate and the negotiated interest rate may differ between types of TCBs, as it does with investor credit TCBs. 9 BAB and RZEDB credits are 35% and 45% of a market-determined taxable bond interest rate for the specific issuer, rather than the Secretary of Treasury.

Tax credit bond stripping

The credits on TCBs are "strippable," meaning they can be separated from the underlying bond. Allowing the credit to be separated from the underlying bond increases the TCBs' appeal and marketability to issuers, investors, and financial intermediaries. In general, a financial intermediary may purchase the TCB, sell the principal to a longer-term investor, and sell the credit stream to another investor wanting quarterly income.

Assume a financial intermediary purchases the $100,000 TCB shown above. The intermediary offers a pension fund the right to the principal part (the $100,000) of the TCB for $90,000 and another investor the stream of credits ($1,980 every quarter for 15 years) for $90,000. Because of the stripping clause, TCBs are more competitive with ordinary bonds.