Introduction to the Inflation Reduction Act

The Inflation Reduction Act of 2023 (IRA) is a landmark bill that aims to stimulate the economy and reduce the rate of inflation by encouraging investment in green energy projects.

One of the main features of the IRA is the provision of tax credits for producing renewable energy and improving energy efficiency. These tax credits can be combined with tax-free bonds, which are debt instruments that offer lower interest rates and are exempt from federal income tax.

This combination can create a powerful financing mechanism for green energy projects as it can reduce capital costs and increase returns on investment.

What are tax-free bonds?

Tax-exempt bonds are bonds issued by state or local governments or their agencies to finance public projects that serve the public good, such as infrastructure, education, healthcare and housing. The interest income from these bonds is not subject to federal income tax and, in some cases, state and local income tax. This makes them attractive to investors looking for low-risk and tax-efficient investments.

Tax-exempt bonds can be divided into two types: general obligation bonds and income bonds.

General purpose bonds are backed by the full credibility and creditworthiness of the issuer. This means that the issuer is committed to using its tax sovereignty to repay the bondholders.

Revenue bonds are backed by a specific revenue source, such as tolls, fees, or rents, generated by the project being financed by the bond. Revenue bonds are riskier than general obligation bonds because they depend on the performance of the project to generate sufficient revenue to repay bondholders.

What are green energy tax credits?

The Green Energy Tax Credits are IRA incentives to encourage 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 credit per kilowatt hour for electricity generated by qualified renewable energy facilities such as wind, solar, geothermal, biomass and hydroelectric power. The PTC is available for 10 years from the date the facility is commissioned and the amount of the credit varies depending on the type and size of the facility.

The ITC is a percentage credit for the cost of acquiring and installing qualified energy assets, such as solar panels, wind turbines, fuel cells, and energy efficient appliances. 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-free bonds and tax credits?

One of the challenges in financing green energy projects is that the timing and amount of cash flows do not match.

Green energy projects typically require high initial investments but generate low and uncertain returns over a long period of time. This makes securing external financing difficult, as lenders may charge high interest rates and short repayment periods to compensate for the risk.

Tax-exempt bonds can help overcome this challenge by providing 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 tax credits come in, as they can reduce equity requirements and increase project profitability. By combining tax-exempt bonds and tax credits, developers and investors can create a leveraged financing structure that amplifies the benefits of both incentives.

Benefits and challenges of combining tax-free bonds and tax credits

The main benefit of the combination of tax-free bonds and tax credits is that it can reduce 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 with longer terms than traditional debt financing. By taking advantage of 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 investment in green energy.

The biggest challenge with 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 implementation. For example, using tax-exempt bonds can limit eligibility and the amount of tax credits because the IRS imposes certain rules and restrictions on how the two incentives interact.

In some cases, energy tax credits can be reduced by up to 15% if the underlying project/property is financed with tax-exempt bonds. This reduction is not a reduction in the tax credit rate, but rather a reduction in the tax credit amount. For example, if the ITC is $100 and the reduction percentage is 15%, the ITC is reduced by $15 to $85.

The use of tax credits may also affect the tax status and reporting obligations of bondholders as they may be subject to an alternative minimum tax or a tax on non-operating income.

In addition, taking advantage of both incentives may require the involvement of multiple parties and intermediaries, such as bond issuers, bond advisors, underwriters, trustees, lenders, equity investors, tax equity investors and accountants, who may have different interests and expectations. Consult qualified professionals and advisors before pursuing this financing strategy.

How we can help

The combination of tax incentives can create an effective financing mechanism that can reduce the cost of capital and increase the return on investment.

However, this financing strategy also brings with it complex and interrelated legal, financial and tax issues that must be carefully planned and implemented. CLA’s qualified tax experts and consultants can provide insights and strategies to help your business find new tax saving opportunities and take advantage of available benefits.