Tax Credit Bonds: A Brief Explanation

This report provides a brief explanation on tax credit bonds (TCBs). 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.



Order Code RL34629
Tax Credit Bonds: A Brief Explanation
August 20, 2008
Steven Maguire
Specialist in Public Finance
Government and Finance Division

Tax Credit Bonds: A Brief Explanation
Summary
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 program, with modifications, for 2006 and 2007. Several bills
have been introduced in the 110th 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.

Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
The Details of Tax Credit Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
QZABs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Qualified Zone Academy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Annual QZAB Limit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Term of QZAB Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
The QZAB Tax Credit Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Arbitrage Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
CREBs, GTCBs, and FCBs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Comparison of TCBs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Investing in Tax Credit Bonds vs. Other Bonds . . . . . . . . . . . . . . . . . . . . . . 6
The Bond Market and TCBs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
List of Tables
Table 1. Comparison of Tax Credit Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Tax Credit Bonds: A Brief Explanation
Introduction
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
(municipal) bonds offer a lower pre-tax interest rate than corporate bonds.1 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 was 4.75%.2 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% instead of the difference between
the taxable rate and the lower tax-exempt rate of 4.75%.3 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 extended the program several
times. In the 107th Congress, the Job Creation and Worker Assistance Act of 2002
(P.L. 107-147) extended QZABs through 2003. In the 108th Congress, P.L. 108-311
extended QZABs through 2005. In the 109th Congress, the Tax Relief and Health
Care Act of 2006 (TRHCA; P.L. 109-432) extended QZABs through 2007. In the
1 For ease of exposition, the phrase “state and local tax-exempt bonds” is replaced by
“municipal bonds” for the remainder of the report.
2 Federal Reserve Board, Table H. 15, “Selected Interest Rates,”
[http://www.federalreserve.gov/releases/H15/data.htm#top], visited Aug. 13, 2008.
3 See CRS Report RL30638, Tax-Exempt Bonds: A Description of State and Local
Government Debt,
by Steven Maguire.

CRS-2
110th 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, 2007, to December 31, 2008. S.
2886 in the 110th 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).
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.
The Details of Tax Credit 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.
QZABs
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.”
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
such public school or program (as the case may be) is designed in cooperation
with business to enhance the academic curriculum, increase graduation and

CRS-3
employment rates, and prepare students for the rigors of college and the
increasingly complex workforce....4
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.
Annual QZAB Limit. 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.
Term of QZAB Debt. 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 principal on the bond being equal to 50%
of the face amount of the bond.”5 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.
The QZAB Tax Credit Rate. 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 included in the
bond holder’s gross income.6 The credit is limited to the bondholder’s current tax
liability; it is “non-refundable.”
4 26 U.S.C. 1397E(d)(4)(A). The private entity must donate an amount equivalent to 10%
of the bond proceeds. Services of employees as volunteer mentors satisfies the 10% private
partnership requirement.
5 26 U.S.C. 1397E. The term of QZABs is found by calculating the following: log(2)/log
(1+r). The variable r is the “discount rate of the average annual interest rate of tax-exempt
obligations having a term of 10 years or more which are issued during the month.”
6 In special cases, some insurance companies may indirectly pay income tax on otherwise
tax exempt debt. In addition, interest paid on private activity bonds may be subject to the
alternative minimum tax.

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Arbitrage Rules. 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.
CREBs, GTCBs, and FCBs
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.
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 any political
subdivision or instrumentality thereof or a 501(c)(3) organization.”7 For purposes of
the FCB program, a qualified forestry conservation purpose must meet the following
criteria:8
(1) Some portion of the land acquired must be adjacent to United States Forest
Service Land.
(2) At least half of the land acquired must be transferred to the United States
Forest Service at no net cost to the United States and not more than half of the
land acquired may either remain with or be conveyed to a State.
7 Sec. 15316(a) of P.L. 110-234.
8 Sec. 15316(a) of P.L. 110-234.

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(3) All of the land must be subject to a native fish habitat conservation plan
approved by the United States Fish and Wildlife Service.
(4) The amount of acreage acquired must be at least 40,000 acres.
Comparison of TCBs
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.
Table 1. Comparison of Tax Credit Bonds
Bond Feature
QZABs
CREBs
GCTCBs
FCBs
Purpose
School
Investment in
Post-disaster
Forest
renovation
renewable
local
conservation
energy
government debt
assistance
I.R.C. section
sec. 1397E
sec. 54
sec. 1400N
sec. 54A & 54B
and Public Law
P.L. 105-34
P.L. 109-58
P.L. 109-135
P.L.110-234
Authorization
expired
expires
expired
expires
status
12/31/2007
12/31/2008
12/31/2006
5/22/2010
Credit rate
Set to insure no
Set to insure no
Set to insure no
Set to insure no
cost or discount
cost or discount
cost or discount
cost or discount
to issuer at a
to issuer at a
to issuer at a rate
to issuer at a
rate equivalent
rate equivalent
equivalent to a
rate equivalent
to a taxable 10-
to a taxable10-
taxable10-yr
to a taxable10-
yr bond
yr bonda
bonda
yr bonda
Credit payment
annual
quarterly
quarterly
quarterly
Credit strippable
no
no
no
yes
Termb
log(2)/log(1+r)
log(2)/log(1+r)
2 years
log(2)/log(1+r)
Issuer
government
an electric coop,
Alabama,
state or political
entity, e.g., LEA
a coop that has
Louisiana, and
subdivision
made loans to
Mississippi
thereof,
100 or more
501(c)(3)
coops,
government
entity
Investor or
bank, insurance
no restrictions
no restrictions
no restrictions
taxpayer
co., or
corporation in
the business of
lending money

CRS-6
Bond Feature
QZABs
CREBs
GCTCBs
FCBs
Partnership
10% of issue
n/a
One-to-one
None though
must be matched
match with state
50% of forest
by private
funds for same
land purchased
business partner
purpose
with bonds must
be transferred to
the USFS
Authorized
$400 million
$1.2 billion
$350 million
$500 million
amount
annually
through 2008
through 2006
1997 to 2007
Allocation
State-by-state
Projects the
AL: $50 million
Projects the
process
based on state’s
Secretary
LA: $200
Secretary
portion of total
determines
million
determines
US population
appropriate
MS: $100
appropriatec
below poverty
million
line
Carryover
Up to two years
n/a
n/a
n/a
Registration /
No
yes; report as
yes
no; report as
reporting
under sec.
under sec.
149(e)
149(e)
a. In contrast to QZABs, CREBs, GTCBs, and FCBs allow the Secretary’s designee to estimate the
appropriate credit rate.
b. For the term calculations, “r” is the average annual interest rate of tax-exempt debt having a term
of 10 years or more.
c. Up to 50% of FCB allocation can be used to satisfy outstanding federal tax debts.
Investing in Tax Credit Bonds vs. Other Bonds
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.

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Evaluating a Tax Credit Bond Investment
t = income tax rate of bond holder
rTCB = pre-tax rate of TCB credit
rmuni = prevailing interest rate on high grade tax-exempt municipal
bonds
rcorp = prevailing interest rate on corporate bonds
Purchase a TCB if:
rTCB > rmuni /(1-t)
or
rTCB > rcorp
The TCB tax credit rate must be greater than (a) alternative tax-exempt
municipal bond interest rate divided by one minus the income tax rate, or
(b) the prevailing 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.
The Bond Market and TCBs. 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.

CRS-8
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 generally prefer deep secondary markets
for assets.9 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 several times and added three new types of TCBs since QZABs
were first issued in 1998.10 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.
9 Source Media, Inc., The Bond Buyer/Thompson Financial 2008 Yearbook, New York, NY,
2008. For more on QZAB investors, see Thornton Matheson, “Qualified Zone Academy
Bond Issuance and Investment: Evidence from 2004 Form 8860 Data,” Statistics of Income
Bulletin
, U.S. Department of Treasury, Internal Revenue Service, Spring 2007.
10 P.L. 106-170, enacted on Dec. 17, 1999, extended the QZAB program two years, through
2001. P.L. 107-147, (Mar. 9, 2002), extended the program another two years, through 2003.
P.L. 108-311, (Oct. 4, 2004), extended the program through 2005. P.L. 109-432, (Dec. 20,
2006), extended the program through 2007.