Turning Income Tax Payable Into Earnings

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The New Markets Tax Credit (NMTC) Program is a two decade old federal tax credit program administered by the Community Development Financial Institutions Fund designed to monetize credits awarded by Department of the Treasury for community revitalization.

A federal tax credit is a dollar-for-dollar reduction of federal income tax payable; it is a permanent reduction of tax in the year the credit is taken. If a bank can acquire them for less than $1, it ends up converting an income tax liability into an earning. The credit creates more net income by reducing the amount in taxes owed.

The CDFI Fund has awarded 18 rounds of NMTCs, totaling $71 billion in tax credit authority. As of October 2022, $60.4 billion in NMTCs have been invested in low-income communities, creating jobs from investments in manufacturing, retail and technology projects. NMTCs are a 39% tax credit paired with a leverage loan. The Office of the Comptroller of the Currency wrote in 2013 that these credits “can help banks meet their financial goals (competitive returns on their equity investments)….[m]eet CRA requirements….[a]nd are a critical tool in helping the credit needs of low-income communities.”2

Of course, as with any equity investment there are risks; risks associated with tax credits include recapture risk, default risk, reputation risk and a lack of liquidity. But these deals are structured with full forbearance from debt that makes the probability of a redemption event unlikely. There’s also less risk at the project level compared with other tax credit programs available to corporations. And a 2017 study found a very low recapture rate.

The average return associated with the NMTC Fund, as of November 2022, outperformed seven-year US Treasurys and seven-year investment grade bonds by more than 2.43x and 1.6x, respectively in 2022 on a pre-tax basis.

Returns represent the internal rate of return of each investment categorized as held-to-maturity. The seven-year investment grade bonds for 2022 was determined based on a benchmark interest rate of the same maturity, plus the ICE BofA US Corporate Investment Grade Option-Adjusted Index. NMTC Fund returns are based on recent pricing.

Accounting Options
Typically, banks use two options for GAAP accounting using ASC 740 provisions:

  • Flow Through Method: The NMTC amount reduces the income tax expense (below the line). Impairment of the investment balance is categorized as an other expense, impacting pretax income (above the line).
  • Deferral Method: The tax credit is recognized as a contra asset (deferred income liability) and amortized into income over the productive life of the investment.

The Financial Accounting Standards Board’s Emerging Issues Task Force is evaluating whether it should expand the proportional amortization method to investments in tax credits beyond LIHTC investments, including investments in NMTCs (below the line treatment), a change many expect to be adopted as early as the first quarter of 2023.

Momeni & Sons Case Study
In 2022, Momeni & Sons, a manufacturer and importer of area rugs, wall-to-wall carpeting and home décor, wanted to establish a 302,600 square foot warehouse and distribution facility in Adairsville, Georgia, to accommodate growing online sales and bring more economic opportunity to the Adairsville community.

Given the magnitude of the project’s size and the rising cost of construction materials, the company needed about  $18.7 million to finance the project; its lender also determined that the project could be supported by the NMTC program. With $14 million in NMTC allocation, Wayne, New Jersey-based Valley National Bancorp was able to provide the tax credit leverage loan and the equity in the deal.

Momeni’s new facility created 100 construction jobs and 98 full-time quality jobs at its completion in August 2022, boosting the local economy of Adairsville. The project provided skills training in conjunction with a local workforce development provider, creating high-quality training and instruction to the area; at least 65% of Momeni’s Adairsville labor force will be minority residents.

New Markets Tax Credits provide a lesser-known opportunity for banks to convert tax liability to earnings, while potentially providing Community Reinvestment Act benefits, deposits and loans. There are syndication options available, which eliminate the need for smaller banks to create an independent infrastructure around the NMTCs.

This overview is for informational purposes only and is intended for recipients having sufficient knowledge and experience to make an independent evaluation of the risks and merits of any financing. The New Markets Tax Credit program is extremely complex. Consult your legal counsel, tax counsel and accountant. This information and opinions included in this overview do not, and are not intended to, constitute legal or tax advice. Dudley Ventures makes no representations or warranties of any kind, express or implied, as to the accuracy or completeness of the information or opinions. © 2022 Dudley Ventures, LLC, a Delaware limited liability company. All rights reserved.

Community Banks Fuel the Future of Renewable Energy

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The transformational Inflation Reduction Act (IRA) contains a number of provisions designed to entice a large numbers of community and regional banks to deploy capital into renewable energy projects across the US.

Large U.S. banks and corporations have made significant renewable energy tax credit investments for over a decade. Through the IRA, there is greater opportunity for community and regional banks to participate.

The act extends solar tax credits, or more broadly renewable energy investment tax credits, (REITCs) for at least 10 more years, until greenhouse gas emissions are reduced by 70%. It also retroactively increases the investment tax credit (ITC) rate from 26% to 30%, effective Jan. 1, 2022. This extension and expansion of ITCs, along with other meaningful incentives included in the act, should result in a significant increase in renewable energy projects that are developed and constructed over the next decade.

Community banks are a logical source of project loans and renewable energy tax credit investments, such as solar tax equity, in response to this expected flood of mid-size renewable projects. REITCs have a better return profile than other types of tax credit investments commonly made by banks. REITCs and the accelerated depreciation associated with a solar power project are fully recognized after it is built and begins producing power. This is notably different from other tax credit investments, such as new markets tax credits, low-income housing tax credits and historic rehabilitation tax credits, where credits are recognized over the holding period of the investment and can take 5, 7, 10 or 15 years.

Like other tax equity investments, renewable energy tax equity investments require complex deal structures, specialized project diligence and underwriting and active ongoing monitoring. Specialty investment management firms can provide support to community banks seeking to make renewable energy or solar tax credit investments by syndicating the investments across small groups of community banks. Without support, community banks may struggle to consistently identify suitable solar project investment opportunities built by qualified solar development partners.

Not all solar projects are created equally; and it is critical for a community bank to properly evaluate all aspects of a solar tax equity investment. Investment in particular types of solar projects, including utility, commercial and industrial, municipal and community solar projects, can provide stable and predictable returns. However, a community bank investor should perform considerable due diligence or partner with a firm to assist with the diligence. There are typically three stages of diligence:

  1. The bank should review the return profile and GAAP financial statement impact with their tax and audit firm to validate the benefits demonstrated by the solar developer and the anticipated impact of the investment on the bank’s earnings profile and capital.
  2. The bank should work with counsel to identify the path to approval for the investment. Solar tax equity investments are permissible for national banks under a 2021 OCC Rule (12 CFR 7.1025), and banks have been making solar tax equity investments based on OCC-published guidance for over a decade. In 2021, the new rule codified that guidance, providing a straightforward roadmap and encouraging community banks to consider solar tax equity investments. Alternatively, under Section 4(c)(6) of the Bank Holding Company Act, holding companies under $10 billion in assets may also invest in a properly structured solar tax equity fund managed by a professional asset manager.
  3. The bank must underwrite the solar developer and each individual solar project. Community banks should consider partnering with a firm that has experience evaluating and underwriting solar projects, and the bank’s due diligence should ensure that there are structural mitigants in place to fully address the unique risks associated with solar tax equity financings.

Solar tax credit investments can also be a key component to a bank’s broader environmental, social and governance, or ESG, strategy. The bank can monitor and report the amount of renewable energy generation produced by projects it has financed and include this information in an annual renewable energy finance impact report or a broader annual sustainability report.

The benefits of REITCs are hard to ignore. Achieving energy independence and reducing carbon emissions are critical goals in and of themselves. And tax credit investors that are funding renewable energy projects can significantly offset their federal tax liability and recognize a meaningful annual earnings benefit.

Helping Commercial Clients Access New Tax Credit

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Helping commercial clients is also an opportunity for banks to increase fee income through a partnerships.

Commercial clients can access a payroll tax refund through the Employee Retention Credit (ERC); ERC providers that specialize in navigating the process can partner with banks to offer this service and increase their noninterest fee income and deposits.

The ERC was born out of the 2020 CARES Act, which is the same relief bill that created the Small Business Administration’s Paycheck Protection Program (PPP) loan. PPP clients may qualify for the ERC, which gives banks an opportunity to monetize their PPP client list. The ERC is easier for banks to implement than the PPP since it is not a loan: it is money that businesses are entitled to receive from the government. Once companies receive ERC funds from the U.S. Department of the Treasury, it’s the business owner’s money to keep.

Initially, the ERC tax credit was available to companies whose operations were fully or partially suspended from March 13, 2020, through Dec. 31, 2020. Back then, the maximum refund a company could receive was up to $5,000 per employee. Then, Congress made several modifications:

1. The Consolidated Appropriations Act extended the ERC to include wages paid before July 1, 2021. The maximum ERC amount was increased to $7,000 per employee and quarter.

2. The American Rescue Plan Act of 2021 included wages paid between July 1, 2021 and Dec. 31, 2021.

3. As of Sept. 30, 2021, the retroactive appeal of the ERC affected businesses that were originally scheduled to receive the ERC from Oct. 1 through Dec. 31, 2021.

Who Qualifies for the Payroll Tax Refund
Thanks to the payroll tax refund, banks that partner with an ERC provider can help their clients capture these rebates, benefiting from the higher deposits in their clients’ accounts. The IRS estimates that tens of thousands of businesses are eligible for the refund, which is available to both essential and non-essential businesses that were impacted by the pandemic. If a company experienced disruptions to commerce, travel or group meetings, it likely qualifies.

When banks empower their commercial clients with business opportunities they can take advantage of, both parties benefit in several ways, including:

Stronger relationships. Helping their commercial clients claim their payroll tax refund gives more trust and credibility.

Expanded services. Banks can set themselves apart from their competitors by offering assistance with navigating the ERC qualification and refund process.

Growth opportunities. With more noninterest fee income and deposits, banks can increase their budgets for other initiatives that help move their business forward.

While business owners may be tempted to go to their CPA to find out if they qualify, it’s recommended to go to an ERC provider that understands the intricacies and nuances involved in assessing eligibility. Choosing a highly qualified professional gives commercial clients a potentially higher refund amount than if they went to a general practitioner.

Banks that partner with an ERC provider can help their commercial clients navigate the payroll tax refund process easily and quickly. This partnership can then expand to additional services that allow banks to scale their commercial client base.