Introduction to the Inflation Reduction Act
The Inflation Reduction Act of 2023 (IRA) is a landmark legislation that aims to stimulate the economy and reduce the inflation rate by encouraging investments in green energy projects.
One of the key features of the IRA is the provision of tax credits for renewable energy production and energy efficiency improvements. These tax credits can be combined with tax exempt bonds, which are debt instruments that offer lower interest rates and are exempt from federal income taxes.
This combination can create a powerful financing mechanism for green energy projects, as it can lower the cost of capital and increase the return on investment.
What are tax exempt bonds?
Tax exempt bonds are bonds issued by state or local governments, or their agencies, to finance public projects that benefit the general welfare, such as infrastructure, education, health care, and housing. The interest income from these bonds is not subject to federal income tax, and in some cases, state and local income taxes as well. This makes them attractive to investors who are looking for low-risk and tax-efficient investments.
Tax exempt bonds can be classified into two types: general obligation bonds and revenue bonds.
General obligation bonds are backed by the full faith and credit of the issuer, meaning that the issuer pledges to use its taxing power to repay the bondholders.
Revenue bonds are backed by a specific source of revenue, such as tolls, fees, or rents, generated by the project that the bonds finance. Revenue bonds are more risky than general obligation bonds, as they depend on the performance of the project to generate sufficient income to repay the bondholders.
What are the green energy tax credits?
The green energy tax credits are incentives provided by the IRA to promote the development and deployment of renewable energy sources and energy efficiency measures. The IRA offers two types of tax credits: the production tax credit (PTC) and the investment tax credit (ITC).
The PTC is a per-kilowatt-hour credit for electricity generated by qualified renewable energy facilities, such as wind, solar, geothermal, biomass, and hydropower. The PTC is available for 10 years from the date the facility is placed in service, and the credit amount varies depending on the type and size of the facility.
The ITC is a percentage-based credit for the cost of acquiring and installing qualified energy property, such as solar panels, wind turbines, fuel cells, and energy efficient equipment. The ITC is available for the year the property is placed in service, and the credit amount ranges from 6% to 50% depending on the type and size of the property and if certain requirements are met.
Why combine tax exempt bonds and tax credits?
One of the challenges of financing green energy projects is the mismatch between the timing and amount of the cash flows.
Green energy projects typically require high upfront capital expenditures but generate low and uncertain revenues over a long period of time. This makes it difficult to secure debt financing, as lenders may demand high interest rates and short repayment terms to compensate for the risk.
Tax exempt bonds can help overcome this challenge, as they can provide long-term and low-cost debt financing for green energy projects. However, tax exempt bonds alone may not be enough to make the projects viable, as they still require sufficient equity to cover the remaining costs and risks.
This is where the tax credits come in, as they can reduce the equity requirement and enhance the profitability of the projects. By combining tax exempt bonds and tax credits, developers and investors can create a leveraged financing structure that enhances the benefits of both incentives.
Benefits and challenges of combining tax exempt bonds and tax credits
The main benefit of combining tax exempt bonds and tax credits is that it can lower the cost of capital and increase the return on investment for green energy projects.
By using tax exempt bonds, nonprofits can borrow at lower interest rates and for longer terms than conventional debt financing. By using tax credits, they can reduce the amount of equity they need to invest and increase their after-tax income. This can make the projects more attractive and feasible and encourage more investments in green energy.
The main challenge of combining tax exempt bonds and tax credits is that it can create complex and interrelated legal, financial, and tax issues that require careful planning and execution. For example, the use of tax-exempt bonds may limit the eligibility and amount of the tax credits, as the IRS imposes certain rules and restrictions on the interaction between the two incentives.
In some cases, the energy tax credits can be reduced by up to 15% when the underlying project/property is financed with tax-exempt bonds. This reduction is not a reduction of the tax credit rate, rather it is a reduction of the tax credit dollar amount. For example, if the ITC is $100 and the reduction percentage is 15%, then the ITC is reduced by $15 to $85.
The use of tax credits may also affect the tax status and reporting obligations of the bondholders, as they may be subject to alternative minimum tax or unrelated business income tax.
Moreover, the use of both incentives may require the involvement of multiple parties and intermediaries, such as bond issuers, bond counsel, underwriters, trustees, lenders, equity investors, tax equity investors, and accountants, who may have different interests and expectations. Consult with qualified professionals and advisors before pursuing this financing strategy.
How we can help
Combining tax incentives can create a powerful financing mechanism that may lower the cost of capital and increase return on investment.
However, this financing strategy also entails complex and interrelated legal, financial, and tax issues that require careful planning and execution. CLA’s qualified tax professionals and advisors can offer insights and strategies to help your organization find new tax savings opportunities and capture available benefits.
This blog contains general information and does not constitute the rendering of legal, accounting, investment, tax, or other professional services. Consult with your advisors regarding the applicability of this content to your specific circumstances.