USDA Build America Bonds can be used for a variety of purposes, including the purchase of technology for schools.

The American Recovery and Reinvestment Act of 2009 (Recovery Act) and the Hiring Incentives to Restore Employment Act (HIRE Act) encourages more activity in the public finance sector by introducing four new kinds of taxable, tax credit, and tax-exempt bonds, expanding authority for existing bond categories, and providing greater financial incentives for institutions to invest in municipal obligations. See the chart on Recovery Act Bond Options for a comparison of the changes in the programs. For readers interested in gaining a better general understanding of the opportunities made available for banks by the Recovery Act funding, please read A Look Inside.

Perhaps most significant for banks, the Recovery Act increases the expense deductions financial institutions may take that are allocable to purchasing or carrying a tax-exempt obligation (e.g., a municipal security). The act also raises the limits for "bank-qualified" bonds, and exempts certain interest earnings on bonds issued in 2009 and 2010 from the alternative minimum tax (AMT).

Generally, interest expense allocable to purchasing or carrying a tax-exempt obligation is not allowed as a federal deduction. (See 26 USC 265(b)(1) and (3).) However, an exception allows a bank to deduct 80 percent of the interest expense allocable to purchasing and carrying a "qualified tax-exempt obligation." (See 26 USC 265(b)(3), 291(e)(1)(B).) This obligation must be sold by a "qualified small issuer," who may not issue more than $10 million in qualified tax-exempt obligations in a calendar year. (See 26 USC 265(b)(3)(C).)

The Recovery Act made two important changes:

• First, it raised the ceiling for a "qualified small issuer" for 2009 and 2010. (See 26 USC 265(b)(3)(G).) For bonds issued in 2009 and 2010, the Recovery Act increases the limit from $10 million to $30 million and applies the limit to the ultimate qualified borrower of pooled financings, which permits larger pool issuances. Thus, for example, qualified 501(c)(3) bonds issued over this two-year period do not count toward the government issuer's $30 million limit.



• Second, for purchases in 2009 and 2010, a bank may deduct 80 percent of the interest expense allocable to purchasing and carrying a tax-exempt obligation from an issuer other than a qualified small issuer, provided that the bank's average adjusted basis in tax-exempt obligations does not exceed 2 percent of its average adjusted basis in all assets. (See 26 USC 265(b)(7).)

These changes are expected to increase bank issuances and holdings of municipal securities in 2009 and 2010, particularly for community banks.

Exemption of Certain Interest Earnings from AMT and Corporate Adjustment

Interest on tax-exempt private activity bonds (but not government or 501(c)(3) bonds) is generally subject to the AMT, and interest on any tax-exempt bonds (other than housing bonds) is generally included in the corporate AMT adjustment based on current earnings. Under the Recovery Act, interest attributable to private activity bonds issued in 2009 and 2010 (including bonds issued to refund private activity bonds issued between January 1, 2004, and December 31, 2008) is not subject to the AMT, and interest attributable to tax-exempt bonds is not included in the corporate AMT adjustment based on current earnings. A refunding bond is treated as issued on the date of issuance of the bond that it is refunding (or the original bond, if more than one refunding has occurred).

New Taxable Bond Programs

Build America Bonds

The Build America Bond (BAB) program is a new type of tax-preferred bond. These bonds can be issued either with a tax credit to investors or with the direct payment option to the issuer. The direct payment option reflects a significant change in the federal government's approach to subsidizing municipal obligations. If the issuer elects the direct payment option, the issuer will receive, on each interest payment due date, a payment equal to 35 percent of the interest payable on that date. Thus, for example, on bonds with an 8 percent yield for the bondholder, the issuer will pay an effective interest rate of 5.2 percent. Alternatively, if the issuer elects the tax credit option for bonds payable at 6 percent, the bondholder will accrue a tax credit equal to 2.1 percent (35 percent of 6 percent) for a total yield of 8.1 percent. Both the interest paid to bondholders and the amounts of any credit they receive are included in taxable income.

Build America Bonds may be used to improve government-owned hospitals, public housing, roads, schools, libraries, parks, and prisons. Build America Bonds may be issued from February 17, 2009, through December 31, 2010 (see Internal Revenue Service (IRS) Guidance on Recovery Act Bond Provisions). A complete list of issuances to date organized by state is available on the Treasury Department Web site. Treasury released a status report on the BABs that indicates broad support for the new bonds in the market place.

Recovery Zone Economic Development Bond Program

The Recovery Zone Economic Development Bond Program is a new taxable bond instrument that may be used for qualified economic development activities in federally designated empowerment zones.  Recovery zone economic development (RZED) bond issuers will receive a direct federal subsidy payment for a portion of their borrowing costs equal to 45 percent of the total coupon interest paid to investors. Thus, on RZED bonds with an 8 percent yield for the bondholder, the issuer will pay an effective interest rate of 4.4 percent. RZED bonds are subject to a national volume cap of $10 billion over the two-year period 2009 to 2010 and must be issued before December 31, 2010.

Bond proceeds may be used for:

• Capital expenditures for property located in a recovery zone.
• Expenditures for public infrastructure and the construction of public facilities in a recovery zone.
• Expenditures for job training and educational programs.
• Reasonably required reserve funds and costs of issuance (up to 2 percent of the proceeds).

New Tax-Exempt Bond Programs

Recovery Zone Facility Bond Program

The Recovery Zone Facility Bond program, created by the Recovery Act, is a new kind of tax-exempt private activity bond. Typically, private activity bonds are taxable, unless specifically exempted by the federal government. Recovery zone facility (RZF) bonds may be used to support trades or businesses operating in areas suffering from economic distress. They may be used for a broad range of privately owned and operated facilities, as long as the facilities are located in designated recovery zones. The bonds are subject to a national volume cap of $15 billion over the two-year period 2009 to 2010 and must be issued before January 1, 2011.

Tribal Economic Development Bond Program

The Tribal Economic Development Bond Program is a new tax-exempt bond program that will allocate up to $2 billion for tribal economic development. The proceeds of these bonds may be used like the proceeds of any tax-exempt bond (including private activity bonds) issued by a state or local government for an unspecified broad range of projects and activities. Projects and activities funded could include sewage facilities, affordable multifamily rental housing, or green building and sustainable design projects. The Recovery Act allows tribal governments to issue economic development bonds without having to satisfy the "essential governmental function" test generally applicable to bonds issued by tribal governments (Internal Revenue Code section 7871(c)). This allows the proceeds from tribal economic development bonds to be used more broadly, stimulating economic development on tribal lands. The bonds may not be used to finance certain gaming facilities or facilities located off the issuer's reservation. Bonds may be issued beginning February 17, 2009. The program has no time limit.

Tax Credit Programs

Increased Authority for Existing Tax Credit Program through Qualified Zone Academy Bonds

State and local governments may issue qualified zone academy bonds (QZABs) to finance qualified zone academies (FAQ). These QZABs may be used to renovate buildings, train and equip teachers, or develop course materials. The Recovery Act raises the annual national qualified zone academy bond cap from $400 million to $1.4 billion in 2009 and provides a new authorization for $1.4 billion in 2010. Follow up clarification includes elimination of issuance restrictions, (see H.R. 2847, the HIRE Act, Sec. 301). This program, originally offered only as a tax credit, is now being offered with the option to receive a direct payment in cash, equivalent to the tax credit value.  

New Authority for Tax Credit Program through Qualified School Construction Bonds

The Recovery Act creates a new category of tax-credit bonds to finance the construction, rehabilitation, or repair of public school facilities, "Qualified School Construction Bonds." The Recovery Act authorizes $11 billion annually in qualified school construction bonds (QSCBs) for 2009 and 2010, with 60 percent of that authority allocated in proportion to the respective amount of local educational grants received by each state under the Elementary and Secondary Education Act. The remaining 40 percent of that authority is allocated to the largest local educational agencies in the nation (as determined by the Treasury in coordination with the U.S. Department of Commerce and the Secretary of Education). A list of the 100 largest school districts as defined by the Treasury Department can be viewed on the Internal Revenue Service (IRS) Web site. QSCB, QSCB, originally offered only as a tax credit, are now being offered with the option to receive a direct payment in cash, equivalent to the tax credit value.

It should be noted that a large local educational agency is defined in the Recovery Act as any local educational agency that is: (1) among the 100 local educational agencies with the largest number of children ages 5 through 17 from families living below the poverty level, as determined by the Treasury using the most recent data available from the Department of Commerce; or (2) one of not more than 25 additional local educational agencies that the Secretary of Education determines (based on the most recent data available) are in particular need of assistance, based on a low level of resources for school construction, a high level of enrollment growth, or such other factors as the Treasury deems appropriate.

The Recovery Act also provides an additional $200 million for 2009 and $200 million for 2010, in annual qualified school construction bond authority to be allocated by the Secretary of the Interior to Indian tribal schools. These funds are in addition to the $11 billion authorized for qualified school construction bonds and can be used for the construction, rehabilitation, and repair of schools funded by the Bureau of Indian Affairs. For more information, see "Part III - Administrative, Procedural, and Miscellaneous Qualified School Construction Bond Allocations for 2009" on the IRS Web site.

Providing Deeper Subsidies

The advantage of these qualified tax credit bonds is that they are designed to provide a deeper subsidy than that provided for tax-exempt bonds. Qualified zone academy bonds and qualified school construction bonds are intended to provide an effective zero percent interest rate. The Treasury Department sets the tax credit rate daily for these bonds at a rate estimated to permit their issuance without interest or discount, which allows the bonds to be issued at par. The issuer then pays back only the principal of the bond, and the bondholder receives federal tax credits (or a direct payment) in lieu of the traditional bond interest. The tax credit (or a direct payment) may be taken quarterly to offset the tax liability of the bondholder.

For these tax credit bonds, credits exceeding a bondholder's tax liability may be carried forward to the succeeding tax year but cannot be refunded. Tax credit bonds differ from traditional tax-exempt bonds in that the tax credits issued through the program are treated as taxable income for the bondholder.

CRA Consideration

The new bond programs authorized by the Recovery Act may be used for a broad variety of public needs and are not restricted to activities that would qualify for CRA consideration. Financial institutions are advised to review each potential investment to determine if it meets the requirements of the CRA regulation.

Investments in qualified zone academy bonds are generally considered qualified investments because they provide community services to low- or moderate-income individuals and revitalizing and/or stabilize low- or moderate-income areas.

In general, bank investments in state and local municipal bonds may receive positive consideration under the CRA if their primary purpose is consistent with the CRA definition of community development and they meet the geographic requirements of the CRA regulation. A loan, investment, or service has as its primary purpose community development when it: (1) is designed for the express purpose of revitalizing or stabilizing low- or moderate-income areas, designated disaster areas, or underserved or distressed nonmetropolitan middle-income areas; (2) provides affordable housing for, or community services targeted to, low- or moderate-income persons; or (3) promotes economic development by financing small businesses and farms that meet the requirements set forth in 12 CFR 25.12(g). Banks receive positive CRA consideration for qualifying activities that benefit their assessment area(s) or the broader statewide or regional area that includes their assessment areas(s). For more information on CRA and the types of activities for which banks would receive positive consideration, refer to the CRA regulation (see 12 CFR 25) and the interagency questions and answers on community reinvestment (see 75 FR 11642, March 11, 2010).