If debt issued by a utility to finance distributed infrastructure can be issued as “tax-exempt bonds,” the utility can achieve significant savings because the interest paid on “tax-exempt bonds” is excluded from gross income for federal income tax purposes because purchasers are willing to accept a lower rate of interest than they would require for comparable taxable debt. Although the federal tax code provides a general rule that interest on bonds issued by state and local governments, including municipal utilities, is tax-exempt, there are a variety of requirements that must be satisfied. These are explained below.
Issuing Governmental Bonds. Generally, municipal utilities seeking to issue tax-exempt bonds for the purpose of financing assets owned and operated by said utility will do so through the issuance of “governmental bonds.” A bond will be a governmental bond and not a “private activity bond” if:
No more than five percent of the proceeds are loaned to a nongovernmental person and
No more than ten percent of the proceeds are used in a private trade or business (“Private Business Use Test”) unless (i) the payments in respect of such private trade or business are no more than ten percent of the debt service on the bonds or (ii) the financed property (or in certain cases other property) secures an amount equal to the 10% of the debt (“Private Payment or Security Test”).
Because these requirements apply to the entire proceeds of a bond issue, a utility may be able to address private activity concerns by including the financing of distributed infrastructure in a larger bond issue financing conventional infrastructure, although the ten percent thresholds are reduced to five percent if the distributed infrastructure is unrelated to the primary purpose of the bond issue.
Private Business Use Test. Private business use of a financed asset is any use other than that by a governmental entity or the general public. Ownership by a nongovernmental entity, leases, management contracts or preferential legal entitlements with respect to the financed assets can create private business use. The Private Business Use Test can present challenges for utilities when issuing tax-exempt bonds for distributed infrastructure that encompasses or extends into private property used in a trade or business. If, however, the financed assets are available for use by nongovernmental entities on the same basis as the general public, then the bond issue will likely fit within the restrictions of the Private Business Use Test and could be issued as tax-exempt bonds.
Private Payment or Security Test. This requirement focuses on payments from the private businesses that use the financed assets and the security for the bonds, as well as potentially other payments directly or indirectly related to such private business use. A bond issued to finance distributed infrastructure would likely fit within the restrictions of the Private Payment or Security Test if:
There is a grant of bond proceeds to a private business owner without an expectation of repayment
Cumulative payments made in respect of the private business use do not exceed 10% of the debt service on the bonds
Weighted Average Maturity. Another requirement for tax-exempt bonds is that the weighted average maturity of the issue not exceed 120 percent of the reasonably expected average life of the financed assets. This limits a utility’s ability to finance distributed infrastructure assets with relatively short economic useful lives with long term tax-exempt bonds. However, this constraint can be addressed by combining short term distributed infrastructure assets with long term conventional assets with a long average life in the same financing.
Notwithstanding a utility’s expectation that the bonds will satisfy the requirements for tax-exemption at issuance (see TIR Toolkit section above), the utility will also need to take appropriate measures to track the use of proceeds throughout the life of the bonds to ensure continuing compliance.
As explained in the “Issuing tax exempt bonds” section of the TIR Toolkit, municipal bond dollars are generally tax free. An entirely separate tax question can arise when utilities use financial incentives to motivate private parties to employ localized water infrastructure solutions:
Are rebates or grants utility customers receive for increasing water efficiency or managing stormwater onsite taxable income?
Answering this question from federal, state, and local tax perspectives can be a key issue when developing and scaling investment in a financial incentive program. Communities across the country have already grappled with these issues and provide useful examples for others facing similar challenges:
In Washington D.C., the utility’s stormwater credit trading program raised local tax issues for area nonprofits participating in the program, as the money they earned from the sale of their stormwater credits potentially threatened their tax exempt status. To address this challenge, the utility worked with other local leaders to revise their municipal code. For more details on this local tax issue click here. And click here to learn more about DOEE’s stormwater program.
In California, the State Legislature has permanently exempted rebates and other financial incentives for water efficient toilets, clothes washers, and certain types of recycled water plumbing from state income tax for both individuals and businesses. Click here to learn more about state tax considerations that might apply to incentive programs in the 41 states that collect income taxes at the state level.
At the federal level, it is possible that consumer rebates and other financial incentives are taxable income. Click here to learn more about federal tax issues, including arguments for non-taxability and options for public water agencies to structure programs to enhance the likelihood that the rebate payments not be taxable to the property owner.
Overview of taxability of financial incentives for localized water infrastructure at a local level
Overview of taxability of consumer rebates for water efficiency and stormwater management at the state level
Overview of taxability of consumer rebates and other financial incentives at the federal level
Read about Washington, D.C.'s Department of Energy and Environment stormwater management ordinance that requires onsite stormwater capture for certain development projects
COMING SOON - Primer on the role rates, fees, and financial incentives play in motivating ratepayers to employ localized water solutions