New Markets Tax Credit: Better Controls and Data Are Needed to Ensure Effectiveness
Published: 2014-07-10T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In recent years, private investors have claimed more than $1 billion in NMTCs annually. The credits are combined with private loans and other public funds to support investments in low-income communities. GAO was asked to review the financial structure of NMTCs.
This report assesses: (1) the complexity and transparency of NMTC financial structures and controls over the size of federal subsidies; (2) what is known about the types and amounts of fees and other costs of the financial structures; (3) what is known about the equity remaining in low-income community businesses after the 7-year credit period; and (4) what is known about NMTC project failure rates. GAO reviewed Treasury NMTC data and surveyed CDEs that allocated credits to 305 projects in 2010-2012.
section_title: What GAO Found
paragraphs: The financial structures of New Markets Tax Credit (NMTC) investments have become more complex and less transparent over time. The increased complexity is due, in part, to combining the NMTC with other federal, state, and local government funds. Based on GAO's survey of Community Development Entities (CDEs) an estimated 62 percent of NMTC projects received other federal, state, or local government assistance from 2010 to 2012. While combining public financing from multiple sources can fund projects that otherwise would not be viable, it also raises questions about whether the subsidies are unnecessarily duplicative because they are receiving funds from multiple federal sources. In addition, in some cases the complexity of the structures may be masking rates of return for NMTC investors that are above market rates. For example, a study done for the Department of the Treasury (Treasury) found an investor apparently earning a 24 percent rate of return, which is significantly above market rates of return. In that case, the investor leveraged the NMTCs by using other public funds to increase the base for claiming the NMTC. Treasury and the Internal Revenue Service issued guidance about allowable financial structures in the early years of the NMTC program, but the guidance has not been updated to reflect the subsequent growth in complexity, such as the use of other public money to leverage the NMTC. Treasury also does not have controls to limit the risk of unnecessary duplication in government subsidies or above market rates of returns. Without such guidance and controls the impact of the NMTC program on low-income communities could be diluted.
The costs of complex NMTC financial structures may not be fully reflected in fees charged by CDEs, and they could be reflected in other costs such as higher interest rates. Treasury has taken steps to ensure businesses are better informed about fees and other costs, but is not collecting these additional data itself. Without these data, Treasury is limited in its ability to analyze NMTC program benefits.
GAO also found that the data on equity remaining in businesses after the 7-year credit period were unreliable because, in part, instructions on what to report are unclear. As a result, at this time it is not possible to determine how much equity remains in low-income community businesses after 7 years.
Similarly, data on NMTC project failure rates were unavailable. GAO reviewed data of performance on loans from CDEs to low-income community businesses as an indicator of whether the businesses will be viable over the long term. However, data on loan performance were also incomplete because some reporting of this information by CDEs is optional. As a result, it is not possible to determine, at this time, the NMTC project failure rate with certainty.
section_title: What GAO Recommends
paragraphs: Treasury should issue further guidance on how other government programs can be combined with NMTCs; ensure adequate controls to limit the risks of unnecessary duplication and above-market rates of return; and ensure that more complete and accurate data are collected on fees and costs, the equity remaining in the business after 7 years, and loan performance.
Treasury agreed with GAO's recommendations to improve data collection on equity remaining and loan performance. Treasury said that a recently formed working group, that includes representatives from the Community Development Financial Institutions Fund and the Internal Revenue Service, is considering GAO's other recommendations.

section_title: Letter
paragraphs: Congress established the New Markets Tax Credit (NMTC) program as  part of the Community Renewal Tax Relief Act of 2000 to encourage  investors to invest in impoverished, low-income communities that  traditionally lack access to capital. Conventional access to credit and  investment capital for developing small businesses, creating and retaining  jobs, and revitalizing neighborhoods is often limited in economically  distressed communities or in communities with large low-income  populations. The NMTC provides investors (individuals, financial  institutions, other corporations, etc.) with a tax credit for investing in  communities that are economically distressed or consist of low-income  populations. The investors are able to claim a credit equal to 39 percent  of eligible investment spread over 7 years.
The NMTC program is administered by the Community Development  Financial Institutions (CDFI) Fund in the Department of the Treasury  (Treasury) which allocates tax credit authority—the amount of investment  which investors use as the base for determining the amount of tax credits  they are eligible to claim—to Community Development Entities (CDE) that  apply for and obtain allocations. These CDEs in turn offer the tax credits  to private investors in exchange for equity investments with the CDEs.  The CDEs then invest the capital they raise in qualified low-income  community businesses. The resulting NMTC financial structures include  the CDEs, investors, and qualified low-income community businesses— as well as the transactions between them—and may also include private  loans and funding from other government programs.
We have issued three reports on the status and initial results of the  NMTC program. You asked us to follow up on these reports and review  the NMTC financial structures and the amount of equity investment  flowing through to qualified low-income community businesses. Our  objectives were to assess: (1) NMTC financial structures in terms of their  complexity, transparency, and their effect on the size of the federal  subsidies going to NMTC projects, as well as controls to ensure that  subsidies are not larger than necessary for the investment; (2) what is  known about the types and amounts of fees and other costs that reduce  the amount of equity reaching low-income community businesses; (3)  what is known about the amount of equity left in the low-income  community businesses after the 7-year credit period; and (4) what is  known about the NMTC projects that are at risk of failing by becoming  economically nonviable.
For more detail on these criteria, see GAO, Tax Expenditures: Background and  Evaluation Criteria and Questions, GAO-13-167SP (Washington, D.C.: Nov. 29, 2012);  GAO, Understanding the Tax Reform Debate: Background, Criteria and Questions,  GAO-05-1009SP (Washington, D.C.: Sept. 1, 2005); and GAO, Standards for Internal  Control in the Federal Government, GAO/AIMD-00-21.3.1 (Washington, D.C.: Nov. 1,  1999). recommendation.Fund on the projected equity remaining in the business for projects  beginning in 2011-2012. The CDFI Fund requires CDEs to project equity  remaining in businesses for loans and investments originating in 2011 or  later. For objective 4, we analyzed data reported by CDEs to the CDFI  Fund that could indicate that a project is experiencing financial distress,  such as whether a loan on a project is delinquent, charged off, or  restructured.  ) For objective 3, we analyzed data from the CDFI  We conducted this performance audit from May 2013 to July 2014 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives. See appendix I for more  details about our scope and methodology.
subsections: section_title: Background
paragraphs: The CDFI Fund is authorized to allocate tax credit authority to CDEs that  manage NMTC investments in low-income community development  projects. The CDEs are domestic corporations or partnerships with a  primary mission of providing investment capital for low-income  communities or low-income persons. Some CDEs are established by  other public or private entities, such as local governments or financial  institutions. Through the CDFI Fund, Treasury awards tax credit authority  to CDEs through a competitive application process. After CDEs are  awarded tax credit authority, they use it to attract investments from  investors who then claim the NMTC. CDEs use the money raised to make  investments in projects (one or more) in low-income communities. In the  11 rounds of allocations since 2003, Treasury, through the CDFI Fund,  has made allocations to CDEs that total $40 billion.
The base for claiming the credit on a project is called the qualified equity  investment (QEI). It equals the credit authority allocated to a project by a  CDE and generally covers a portion of the total project costs. The equity  in the QEI includes money provided by NMTC investors but may also  include money from private lenders or other government entities. The  NMTC, which is equal to 39 percent of the QEI, is claimed over 7 years— 5 percent in each of the first 3 years and 6 percent over each of the last 4  years. In recent years, private investors have claimed more than $1 billion  in NMTCs annually. When the QEI does not cover the entire project cost,  the NMTC financing is supplemented by other financing outside the  NMTC allocation.
CDEs are required to invest the funds they receive in qualified low- income community investments, which include, but are not limited to,  investments in operating businesses and residential, commercial, and  industrial projects. Although the range of activities financed by CDEs  varies, about half of NMTC investments have been used for commercial  real estate projects. The program expired in 2013 but legislation has been  proposed to extend it, and the President requested a permanent  extension in his fiscal year 2015 budget proposal.
section_title: The Financial Structures of NMTC Investments Have Become More Complex and Less Transparent While Treasury Guidance Covers Only the Simpler Structures
paragraphs: NMTC investors have developed financial structures that increase the  amount of other funding from either private or public sources that are  used with the NMTC—a process that is called increasing the leverage on  the investment. These structures can increase the amount of federal  subsidy to a project and can result in projects being undertaken that  would not otherwise have been started for lack of sufficient funding.  However, they also increase the complexity of the financial structures by  adding more parties and more transactions, which in turn reduces  transparency and may increase the cost in terms of fees and other related  transactions costs. An assessment of the NMTC program as a whole  requires complete information on all the costs and benefits attributable to  the NMTC, including these administrative and compliance costs.
Figures 1-4 are simplified illustrations of these increasingly complex  financial structures.
In 2003, the Internal Revenue Service (IRS) confirmed the ability to use  private funding to leverage a NMTC structure. Also, in 2004, Treasury  issued final regulations generally allowing the NMTC to be combined with  other tax credits. However, neither Treasury nor IRS has specifically  confirmed the ability to use other federal or state funding to increase the  leverage on NMTC investments.
subsections: section_title: In Practice, NMTC Financial Structures Are More Complex
paragraphs: Many NMTC projects have financial structures that are more complex  than the simple examples in figures 1 through 4. According to CDFI Fund  data, 21 percent of projects originating in 2010 through 2012 had financial  structures involving more than one CDE. In addition, 21 percent of  projects had four or more transactions involving financial flows (such as  loans from the CDEs to the LIC business). The NMTC financial structures  have become more complex over time. We estimated that 41 percent of  NMTC investments were made using one of the leveraged models in  2006, while more recent industry estimates state that more than 90  percent used such leverage in 2013.
The simplified structures in our examples also do not show some of the  complexities that are required for the purpose of acquiring the tax benefit.  For example, when the public funds are leveraged, as in figure 4, a pass- through entity that is disregarded for tax purposes is established to route  the flow of funds back from the low-income community business to the  investment fund to claim the NMTC. The complexity of the structures may  reduce transparency by making it more difficult to trace the flow of private  and public funds and the benefits from the tax subsidies. For example,  investors can leverage other tax credits with the NMTCs to gain access to  other tax benefits such as when the tax credit for solar equipment is  leveraged to claim additional NMTCs and also claim accelerated  depreciation deductions based on the solar equipment.
However, as mentioned above, this complexity can have benefits  because it may result in projects getting financing they could not get  otherwise. For example, combining assistance from other government  programs with the NMTC, as in figures 3 and 4, could finance projects  that would not be viable if they had to rely on only the NMTC and private  lenders for financing as in figure 2.
subsections: section_title: A Majority of NMTC Projects Used Other Public Funds in 2010-2012
paragraphs: Based on our survey of CDEs with projects originating in 2010-2012, the  use of other public sources of funds with the NMTC is widespread (as  shown in Table 1). An estimated
Sixty-two percent of all NMTC projects received other public funding— funds from federal, state or local public sources;
Thirty-three percent of all NMTC projects received other federal
Twenty-one percent of all NMTC projects received funding from  multiple other government programs.
Among the most frequently used other federal sources by NMTC projects  in our survey were historic tax credits (HTC) and tax-exempt bonds for  private non-profit education facilities. In addition, for a number of NMTC  projects in our survey, small business participants obtained loans  guaranteed by the Small Business Administration. The other federal funds  most often leveraged with the NMTC projects in our survey were the  historic tax credits, Recovery Zone bonds and tax-exempt bonds for  private non-profit education facilities. The state and local funds most  frequently leveraged with the federal NMTC were state historic tax credits  and state new markets tax creditsfrom our survey).
section_title: Complex NMTC Financial Structures May Mask Investments with Rates of Return That Are Higher Than Necessary
paragraphs: The competitive or market return should be sufficient to attract enough  investors to fund the project because it reflects the return on comparable  investments with similar risk. In figures 1 through 4 above, we assumed  for illustrative purposes that the competitive market rate of return was 7  percent. We also assumed that NMTC investors provided enough equity  to the project (perhaps because of competition for the credits) that the  credits claimed over the 7-year compliance period provided a market  return.
NMTC industry representatives have argued that competition for credits  by potential investors and competition between CDEs for credit  allocations works to ensure returns on NMTC investments are kept at  market rates commensurate with NMTC investor’s risk. The NMTC  investor’s level of risk depends on the financial structure that the investor  uses. For example, when the NMTC investor uses a leveraged  investment model, the investor does not generally share in the riskiness  of the project. Unless the investor is also the leveraged lender or has  some other financial interest in the project, it is not exposed to any risk  from project failure because such an event generally does not stop the  investor from claiming the credit.
Some evidence suggests that some investors may receive returns that  are above-market and therefore more than the necessary subsidy  required to attract the funds. In a case study reported by the Urban  Institute, an investor appeared to put in about $500,000 of NMTC equity  to claim $1.2 million of NMTCs representing a return of about 24 percent  compounded annually. The NMTC was leveraged entirely with $2.5  million of federal and state HTCs without use of a conventional leveraged  loan in the NMTC structure. As a result, 83 percent of the qualified equity  investment on which an investor claimed NMTCs was provided by other  federal and state tax credit programs.
However, the Urban Institute study authors said that, because of the  complex financial structure, they could not rule out the possibility that the  investor supplied other, non-NMTC funds to the project and at a lower  rate of return. They noted that the NMTC financing was combined with a  conventional loan outside the NMTC structure, owner equity, and a loan  from the local municipality. If the NMTC investor supplied some of these  additional funds, it is possible that the investor’s overall rate of return may  have been lower and more in-line with the market return.
section_title: Guidance and Controls Do Not Exist to Prevent Above-Market Rates of Return or Unnecessary Duplication and Costs
paragraphs: Internal controls should provide reasonable assurance that operations  and use of resources are efficient. In the context of the NMTC program,  the resources administered by Treasury include the tax benefits claimed  by the NMTC investors. One NMTC control has been Treasury and IRS  guidance on allowable financial structures. The Secretary of the Treasury  has the authority to limit how other federal tax benefits are used with the  NMTC and the Secretary has used this authority to prohibit its use with  the Low-Income Housing Tax Credit (LIHTC). While an IRS revenue  ruling, issued in 2003, allowed using debt to leverage NMTC equity, the  ruling did not explicitly address using other public funds, such as other tax  benefits, to leverage the NMTC as in figure 4.
Controls do not exist to monitor and prevent unnecessary use of other  public funds to supplement the NMTC. As already noted, Treasury,  through the CDFI Fund, does not collect information about the specifics of  other public funding. For the CDFI Fund, Treasury does not have controls  to limit the risk of cases like the example from the Urban Institute study  where other public funds were used to expand the NMTC base and  apparently generate a 24 percent rate of return for the NMTC investor.
We believe that such controls could take a variety of forms and would  have to be assessed relative to any added compliance and administrative  costs. A control that would provide greater clarity about tax subsidies  could be achieved by requiring CDEs to report the NMTC investor’s  overall rate of return on the NMTC project. As suggested by the Urban  Institute example, this information would allow an assessment of whether  the NMTC investor is earning a market return commensurate with the risk  on its entire investment. With this information, an additional control could  be implemented that would require CDEs to justify rates of return above a  certain threshold by explaining why this project was so risky that it  required a greater-than-market rate of return. Other controls that could be  considered include caps on rate of returns and mechanisms to ensure  competition among NMTC investors sufficient to prevent above-market  rates of return. The decision to adopt any of these controls would require  that Treasury compare the benefits of the controls with any compliance  costs from added complexity for taxpayers and administrative costs for  Treasury from collection and evaluation of the data and monitoring the  controls once they are put in place.
The complexity of the financial structures creates a lack of transparency  for taxpayers and IRS, and can increase both the risk of higher than  needed NMTC rates of return and investment transactions costs.  Combining multiple investment sources may help some NMTC projects to  obtain sufficient financing to proceed. Indeed, NMTCs are often referred  to as “gap financing” that can be added to other financing. Some projects  may not require NMTC funding. The Urban Institute study estimated that  about 20 percent of projects in the first 4 years of the program showed no  evidence of needing NMTCs to proceed while about 30-40 percent did  with 30 percent uncertain.
However, even in the case where the NMTC funding is necessary, the  intricate patterns of investment flows through NMTC structures, where  multiple sources may be mingled and later dispersed, make it difficult to  determine who is receiving subsidies and whether the return to NMTC  investors is higher than necessary. In addition, the network of  transactions in the NMTC financial structures increase costs both in terms  of explicit CDE fees and other resources used to pay the legal and  accounting costs necessary to establish the entities that make the  transactions.
section_title: Fees and Retentions Reduce the Available NMTC Equity but Lack of Transparency Makes the Size of the Reduction Uncertain
paragraphs: Fees and retentions directly reduce the amount of tax subsidized equity  investment that is available to low-income community businesses but  these costs do not represent the only way that equity can be reduced.  The costs associated with financial structures could also appear in the  form of higher interest rates, especially when the investor and leveraged  lenders are related parties. In listening sessions organized by CDFI Fund  officials, some CDEs reported that comparison of the fees that they  charged to the fees charged by integrated investors/lenders were  inaccurate because of the ability of integrated investors/lenders to receive  compensation in other ways.
The fees, interest, and other costs that can offset one another (a low fee  may be offset by a high interest rate) also reduce transparency by making  the net effect on the tax subsidized equity reaching the low-income  community business hard to determine. Officials at the CDFI Fund are  attempting to address this issue by requiring CDEs to provide a  disclosure statement to low-income community businesses about the size of tax subsidized equity and how it is affected by fees and interest rates.The new requirement that CDEs disclose to the low-income community  businesses all transactions costs, fees, and compensation could help  those businesses understand the final net benefit to the project being  financed with NMTCs. However, because Treasury does not require the  CDFI Fund to collect the CDE disclosure statements itself, the CDFI Fund  database has incomplete information about fees, interest, and other  costs. Without such complete information the Treasury is limited in its  ability to analyze the final net financial benefit of NMTC investments to  low-income community businesses.
subsections: section_title: CDE Fees and Retentions Reduce the NMTC Equity Available to the Low- Income Community Businesses
paragraphs: Our analysis shows that fees and retentions by the CDEs reduced the  $8.8 billion of NMTC investment available to the businesses in 2011-2012  by about $619 million or 7.1 percent. The initial reduction occurred as part  of the NMTC investment that the CDEs retain to cover administrative  costs before investing the remainder in the project. The CDEs then also  charge fees over the course of the 7-year compliance period that further  reduces the equity available to the project. These fees can take the form  of front-end or origination fees at closing, on-going, or asset management  fees during the compliance period, and closing fees at the end of the  compliance period. Table 2 shows the fees and retentions measured as a  percentage of NMTC investment that reduce the equity that is available to  the businesses. In addition, the projects may also incur third-party  transaction costs for NMTC related accounting or legal services not  provided by the CDEs. The CDEs are not required to report these other  third-party transaction costs to the CDFI Fund.
section_title: Higher CDE Fees and Retentions Are Associated with More Complex Financial Structures
paragraphs: Our analysis also shows that the amount of fees and retentions charged  is strongly associated with the amount of NMTC investment in the project:  the amount of NMTC investment accounts for about 50 percent of the  variation in fees across projects. Although the CDFI Fund does not  currently collect data that directly measure the complexity of investment  structures, it does collect data on the number of investment transactions  that occur on a NMTC project. These transactions often represent loans  and investments to the business from different entities such as multiple  CDEs, and can therefore be used as a proxy for more direct measures of  complexity. Our regression analysis of these data shows that higher fees  and retentions are associated with more complex structures as indicated  by the number of transactions (see table 3 for details of this association  between fees and retentions and financial structure, and other  characteristics of the NMTC project). Fees and retentions are generally  described by NMTC participants as reflecting mostly fixed costs, which  would be more consistent with fees decreasing in proportion to the total  size of the NMTC investment.
section_title: CDEs That Reported They Charged No Fees or Retentions Illustrates the Program’s Lack of Transparency
paragraphs: For about 20 percent of projects originating in 2011-2012, CDEs reported  to the CDFI Fund that they charged zero fees or retentions on these  projects (see figure 5). However, it seems unlikely that the services  provided by the CDEs were uncompensated. While the payment may  have come in different forms, a lack of transparency makes it hard to  readily determine how much of the NMTC investment is being reduced  and by what means. For example, NMTC program participants have  suggested that these projects with no fee costs may be more integrated  investments where banks or other large institutions may be lenders as  well as investors. In this case, low fees may be offset by higher interest  rates. We found some indirect evidence of this in another regression  where the projects with no fees or retentions were analyzed relative to all  the projects that had fees and retentions. Here, the analysis showed that  the projects with higher average interest rates were more likely to charge  no fees and retentions. For this subgroup of projects, the positive  relationship between fees and interest rates that we found when we  analyzed all the projects (as shown in table 3) is reversed.
section_title: Data on NMTC Equity Remaining in the Low-Income Community Businesses Are Not Sufficiently Complete or Accurate
paragraphs: Projects that have considerable equity are more likely to have better loan- to-value ratios and are generally more likely to obtain loans with better  terms than projects without their own equity. For this reason, the larger  the amount of equity remaining in the project, the greater is the likelihood  that the project will continue on its own without any further government  subsidies. However, the data available from the CDFI Fund reflect only  the equity left by NMTC investors and may not give a complete picture of  the economic viability of the business because it does not include other  forms of equity, such as those from retained earnings for a successful  business. Furthermore, the CDFI data on equity left in the business are  not sufficiently reliable because they are incomplete and not accurate  enough to capture program performance. According to our standards for  measuring program performance, several elements should be considered  when examining the quality of agency performance data including  accuracy and completeness.
However, our review showed that about 60 percent of projects originating  in 2011-2012 had inconsistencies that made these data unreliable.  Examples of these inconsistencies are:  Incomplete data: One or more CDEs involved in the project did not  report any values making it impossible to calculate an amount for the  entire project.
Inaccurate data: Equity remaining was projected to equal or exceed  100 percent of all NMTC investments in the project. These amounts  are not valid because they exceed the amounts of the original equity  loan.
Zero values: Some CDEs may be reporting a zero value because  they do not intend to leave equity in the project. But according to CDFI  Fund officials, other CDEs may intend to leave equity in the project,  but reported zero value for accounting reasons because the charge  would not be recorded until a later date. Thus, the zero values may be  understating the equity available to the low-income community  businesses.
We determined that one cause of data unreliability was the unclear  instructions in the manual for entering data into the CDFI Fund’s systems.  The manual does not clearly explain the time period for which information  should be reported, which may have led to the CDEs reporting according  to different accounting rules. Incomplete and inaccurate data result in an  inability to use the data to track an important indicator of the likely  performance of the NMTC projects after the compliance period ends. As a  result, it is not possible to determine from these data the amount of equity  to remain in the low-income community businesses after the 7-year credit  period.
section_title: CDFI Fund Data on Distressed Projects Are Not Sufficiently Reliable
paragraphs: CDFI Fund data on projects experiencing financial distress, such as the  number of days a loan is delinquent, track program performance in that  they indicate how likely a project is to continue in business during and  after the credit period. These indicators of financial distress must be  weighed against other NMTC program goals. Another program goal is to  encourage investors to invest in projects that may be more risky because  they are located in low-income communities. Regardless, reliable  performance data are needed to administer the program.
Our review of CDFI Fund data on the current status and performance of  loans to NMTC projects showed inconsistencies that made these data not  sufficiently reliable to determine the number and extent of projects  experiencing financial distress. Examples of these inconsistencies  include:  Incomplete data: Ninety-nine percent of projects reported current  loan status (a mandatory field), but approximately 30 percent of  projects omitted additional information for the other potential  indicators of distress such as the number of times a loan has been  restructured, the number of days the loan is currently delinquent, and  the dollar amount of any loan that has been charged off (optional or  conditionally-required fields).
Inaccurate data: Potential inaccuracies appear when we compared  CDEs’ descriptions of troubled projects from their NMTC allocation  applications with indicators of distress for those same projects in CDFI  Fund databases. In their 2012 applications, CDEs described 193  projects with delinquent, defaulted, or impaired loans in sufficient  detail that we could identify those projects in the CDFI Fund data. But  49 of these projects showed no indications of distress in the data.
The causes of data unreliability were unclear instructions and optional  reporting. CDEs enter their data into the CDFI Fund’s electronic  database. How they enter the data is determined by instructions provided  by the CDFI Fund. We found a lack of clarity in these instructions that  prevented us from being confident that the data provided an accurate  measure of distress. For example, the instructions did not clearly  distinguish restructured loans from refinanced loans. However,  refinancing may not be an indicator of distress. It can occur for a variety  of economic reasons. In addition, the data were incomplete because  reporting some information was optional. Without accurate and complete  data, the CDFI Fund does not have sufficient information to track program  performance related to the future viability of the NMTC funded projects.  CDFI Fund officials told us that they are changing all the loan  performance data points to make them mandatory.
subsections: section_title: Difficulties in Determining Whether or Not a Project Has Failed
paragraphs: Project failures could significantly affect program performance by limiting  its social and economic outcomes in low-income communities. However,  determining when a project has failed is difficult. Projects that seem to be  in difficulty based on the indicators of financial distress can become  financially sound again. Some CDEs in their 2012 applications described  successful restructurings of projects experiencing financial difficulty. But  other projects are in situations where recovery seems unlikely or the  CDEs have in fact written off the projects (see text boxes 1 and 2 for  details of examples of both types of outcomes).
The CDFI Fund is developing additional tools to collect better information  on failed projects. As discussed above, their current measures of financial  distress are inaccurate or incomplete. However, even if the data are  improved, the financial distress measures may not accurately identify  project failures because the projects can recover from distress. The CDFI  Fund is attempting to rectify this measurement problem with a close-out  report which is intended to collect additional information on the status of  the business at the end of the 7-year compliance period, such as whether  a business continues to operate or a real estate project has been put into  service.
subsections: section_title: Examples Illustrating Difficulties in Determining if a Project Has Failed
paragraphs: Text Box 1: Meat processing plant investment that failed.
An $8 million NMTC investment in a meat processing company  involving two loans and one equity investment from one CDE.
According to news accounts, the investments were needed to address  liquidity problems created by an expansion of this ongoing business  that employed about 300 people.
According to the CDE’s 2012 reapplication, the investments became  impaired soon after the CDE made the investments when the  leveraged lender limited the company’s ability to borrow from its credit  line, which forced the company into bankruptcy.
The CDE unsuccessfully sought alternative financing for the company  but still suffered a loss of $5.2 million.
In the CDFI Fund data, one loan and one equity investment are  reported as “charged off” for the full dollar amounts. The other loan is  reported as “closed” but no amount charged off.
Text Box 2: Troubled college construction project that recovered.
A college construction project involving three CDEs and several NMTC  loans.
In their 2012 reapplications for NMTC allocations, two of the CDEs  reported that their loans for the project became delinquent for as much  as 480 days because of construction delays and the economic  recession of 2008.
The two CDEs reported that they worked with the borrower to  rebalance the budget and bring in additional sources of financing.
At the time of their applications, the two CDEs reported that all the  previous interest was paid and all subsequent interest payments had  been on time.
The loans from the two CDEs show indications of poor performance  (periods of delinquency) in CDFI Fund data.
The third CDE did not report any delinquent or impaired loans in its  2012 reapplication, and its loans do not show any indications of poor  performance in CDFI Fund data.
section_title: Conclusions
paragraphs: The potential impact of the NMTC in promoting economic development in  designated low-income communities is diluted if the NMTC provides an  above-market rate of return. Similarly, the impact of a combination of  assistance from government programs is diluted if in the same cases the  combination of assistance is unnecessarily duplicative. Treasury  guidance and controls that are designed to limit these risks can help  ensure the NMTC program realizes the greatest possible impact on low- income communities.
Complete and reliable information is a vital component of assessing  program effectiveness. While the complexity of the NMTC financial  structures makes gathering information a challenge, there are several  aspects of these structures where better information would aid in  understanding the effectiveness of the program. These include the extent  to which fees, interest rates, and other costs reduce the NMTC equity  flowing to low-income community businesses, the amount of equity  available to the low-income community businesses at the end of the 7- year compliance period, and the number of projects that failed or are at  risk of failing.
section_title: Recommendations for Executive Action
paragraphs: We recommend that the Secretary of the Treasury take the following  actions:  Issue guidance on how funding or assistance from other government  programs can be combined with the NMTC including the extent to  which other government funds can be used to leverage the NMTC by  being included in the qualified equity investment.
Ensure that controls are in place to limit the risk of unnecessary  duplication at the project level in funding or assistance from  government programs and to limit above market rates of return, i.e.,  returns that are not commensurate with the NMTC investor’s risk.
Ensure that the CDFI Fund reviews the disclosure sheet that CDEs  are required to provide to low-income community businesses to  determine whether it contains data that could be useful for the Fund to  retain.
Ensure that the CDFI Fund clarifies the instructions for reporting the  amount of any equity which may be acquired by the low-income  community business at the end of the 7-year NMTC compliance  period.
Ensure that the CDFI Fund clarifies the instructions it provides to  CDEs about reporting loan performance and make the reporting of  that data mandatory.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this product to Treasury for comment on June 11,  2014. In its written comments, reproduced in appendix IV, Treasury  concurred with two of our recommendations and reported that the other  recommendations are under consideration. The CDFI Fund also provided  technical comments that were incorporated, as appropriate.
Treasury said that it is considering our recommendations to issue further  guidance on how other government programs can be combined with  NMTCs, and to ensure that adequate controls are in place to limit the  risks of unnecessary duplication and above-market rates of return.  Treasury reported that our recommendations would be reviewed in  consultation with a recently formed working group that includes  representatives from the IRS and the CDFI Fund to discuss potential  administrative or regulatory changes.
Treasury said that it is considering our recommendation about reviewing  data presented in the disclosure sheets that CDEs are required to provide  low-income community businesses. As our report states, not all  information on the disclosure sheets, such as third-party transactions  costs, is reported to the CDFI Fund. This additional information on the  disclosure sheets could be useful for the CDFI Fund to retain.
Treasury agreed with our recommendation to clarify instructions for  reporting any equity amounts that may be acquired by the low-income  community business at the end of the compliance period. Treasury also  agreed with our recommendation to clarify instructions to CDEs about  reporting loan performance and make this data reporting mandatory.
As agreed with your office, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to the appropriate  congressional committees, the Director of the CDFI Fund, and other  interested parties. In addition, the report will be available at no charge on  the GAO website at http://www.gao.gov.
If you or your staff have questions about this report, please contact me at  (202) 512-9110 or at whitej@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. GAO staff who made key contributions to this report are  listed in appendix V.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: The objectives of this report were to assess: (1) New Markets Tax Credit  (NMTC) financial structures in terms of their complexity, transparency,  and effect on the size of the federal subsidies going to NMTC projects as  well as controls to ensure that subsidies are not larger than necessary for  the investment; (2) what is known about the types and amounts of fees  and other costs that reduce the amount of equity reaching low-income  community businesses; (3) what is known about the amount of equity left  in the low-income community businesses after the 7-year credit period;  and (4) what is known about NMTC projects that are at risk of failing by  becoming economically nonviable.
For our first objective, we reviewed the NMTC literature and interviewed  representatives of community development entities (CDEs) and  researchers who have evaluated the program to determine how the  financial structures have evolved. To assess the complexity and  transparency of NMTC investment structures, we applied criteria from our  prior work on evaluating tax expenditures. We also applied criteria from  federal government internal control standards to assess whether controls  are present to ensure that subsidies are not larger than necessary for a  NMTC project.
To report on the number, types, and funding amounts of other federal  programs used on NMTC projects, we designed and implemented a web- based survey to gather information on how projects were financed from  the CDEs responsible for the project. Our survey population consisted of  randomly selected NMTC projects with all loans and investments closing  on or after January 1, 2010. Restricting the survey population to NMTC  projects within our study’s time period left us with a total of 1,265 projects  in the population. We selected a stratified sample of 305 projects. From  the first strata, defined as those projects for which there is an indication  on the underlying population file that at least one of the funding sources  was public dollars, we selected 126 projects. From the second strata,  defined as all other projects, we selected 179 projects. Although some  projects in the second strata could actually have public dollars, this  stratification helps ensure that our sample has enough of these cases to  produce estimates of that domain.
The survey asked the CDEs a combination of questions that allowed for  open-ended and close-ended responses with regard to federal, state,  local, and private funding sources. We pre-tested the content and format  of the questionnaire with four knowledgeable CDEs and made changes  based on pre-test results. The survey was a web-based survey. We sent  an activation e-mail for the survey on March 7, 2014, and closed the  survey on April 4, 2014.
The practical difficulties of conducting any survey may introduce errors,  commonly referred to as non-sampling errors. For example, differences in  how a particular question is interpreted, the sources of information  available to respondents, how the responses were processed and  analyzed, or the types of people who do not respond can influence the  accuracy of the survey results. We took steps in the development of the  survey, the data collection, and the data analysis to minimize these non- sampling errors and help ensure the accuracy of the answers that were  obtained. A second independent analyst checked all the computer  programs that processed the data. In instances where multiple CDEs  responded about the same project, we manually merged the data  together into a representative single project following the Community  Development Financial Institutions (CDFI) Fund’s practices, such as  reporting the highest value as the default estimate.
We obtained responses for 214 of the 305 projects in our sample for an  overall response rate of about 70 percent. Population estimates were  produced by weighting the sample data from the responding projects to  account for differing sampling rates for projects funded with public dollars  and those funded without public dollars. We have treated the respondents  as a stratified random sample and calculated sampling errors as an  estimate of the uncertainty around the survey estimates. All percentage  estimates based on this sample have 95 percent confidence intervals of  within +/- 7 percentage points of the estimate itself. For other numeric  estimates, the 95 percent confidence intervals are presented along with  the estimates themselves. We are 95 percent confident that each of the  confidence intervals in this report will include the true values in the study  population.
To address the last three objectives, we analyzed data from the CDFI  Fund on NMTC investments in low-income community businesses from  2003 through 2012. The CDFI Fund requires all CDEs that have been  awarded NMTC allocations to submit an annual report detailing how they  invested the qualified equity investment (QEI) proceeds in low-income  communities. These reports must be submitted to the CDFI Fund by the  CDEs, along with their audited financial statements, within 6 months after  the end of their fiscal years. CDEs are required to report their NMTC  investments in the CDFI Fund’s Community Investment Impact System  (CIIS) for a period of 7 years. Due to a time lag in reporting, NMTC  investments reported in CIIS are less than the total amount allocated for  the NMTC program. Given that the CDFI Fund requires CDEs to report  information on project characteristics and financing once a year, CIIS  data may not capture the most current information for all existing projects.  However, the CIIS data that we used represent the most current available  information as of December 2, 2013 on the status of the program. We  interviewed CDFI Fund officials with knowledge of CIIS about the steps  they take to ensure its accuracy. Based on GAO’s criteria for valid data— that they be sufficiently accurate and complete to capture program  performance—we also determined the data on fees and retentions we  used in this report were sufficiently reliable for our purposes (see below  for discussion of the data we found unreliable for our purposes).
Seventy-three projects were excluded because they had loans and investments  originating both before and after December 31, 2010, and 49 projects were excluded  because one or more CDEs appeared to have reported fees data incorrectly by reporting  fees as a percentage of the QEI rather than as basis points as instructed by the CDFI  Fund. to calculate the total dollar amounts of fees. We compared our final  results to other data on fees submitted by CDEs when applying for NMTC  allocations in 2010 and 2011.
We attempted to compare these costs to costs on non-NMTC  investments by reviewing industry data and academic studies on fees,  and interviewing industry and tax credit experts. We also reviewed written  and oral comments made by CDEs and industry experts to the CDFI  Fund in response to a November 7, 2011, Federal Register notice  soliciting comments on several possible NMTC program changes. The  CDFI Fund specifically requested comments on whether additional rules,  restrictions, and requirements should be imposed related to fees and  expenses charged by CDEs. The CDFI Fund also held three listening  sessions in December 2012 and January and February 2013 with a total  of 45 CDE and industry experts. We reviewed the transcripts of these  listening sessions and concluded from these reviews that the types of  projects funded by the NMTC are so varied that we could not conduct a  valid comparison of fee costs with those on non-NMTC projects.
We attempted to determine the amount of equity that remains in low- income community businesses by analyzing data reported by CDEs to the  CDFI Fund on equity projected to remain in NMTC projects at the end of  the 7-year credit period. We analyzed these data at the project level for  842 projects with loans and investments originating in 2011 and 2012.  Starting with the 2011 reporting period, the CDFI Fund began requiring  that, if applicable, CDEs report the projected amount of any equity or debt  investment which may be acquired by the low-income community  business as the result of a put/call option or other arrangement for loans  and investments originating after December 31, 2010. After reviewing all  2,249 transactions for all 842 projects, we determined that data were  usable for only 363 projects (about 40 percent), and therefore the data  could not be used to give sufficiently reliable descriptions of the equity  remaining in the project for our purposes. We found the following  problems with the data that made the values unreliable for our report.
For 201 projects, no data were reported by one or more of the CDEs  involved in those projects. We concluded that in these cases we could  not determine: (1) how many of these projects were non-leveraged  where the failure to project a residual value might be expected; (2)  how many indicated a true intention not to leave any equity in the  project; and (3) how many were simply errors or omissions.
For another 143 projects, one or more CDEs involved reported a total  projected residual value of $0. We concluded in these cases that the  implications of zero for equity remaining were ambiguous. According  CFDI Fund officials, some CDEs may in fact do not intend to leave  any residual equity for the business to obtain at the end of the 7-year  period. However, other CDEs may project $0 remaining now when in  fact they intend to designate the amount of equity at a later date.  These CDEs may be reporting a zero value at this time due to an  individual CDE’s internal practices or accounting rules particular to the  CDE’s form of incorporation. That is, the CDEs would not report a  projected or final residual value until the put/call option was exercised  by the business.
Of the remaining 498 projects, 135 projects had data showing that the  total projected residual value for these projects appeared to be  overstated. Some data showed that one or more CDEs reported  projected residual values greater than or equal to the original equity  investment values. In most of these cases, the CDEs appeared to  have incorrectly reported a projected residual value for both leveraged  loans and equity investments. Based on the typical leveraged model  structure, the CDEs should have only reported the residual value of  the equity investments. In other cases, one or more CDEs involved in  a project reported the projected residual value of the equity  investment twice—once as value for the equity investment, and then  repeated it as a value for the leveraged loan. As a result of these  reporting errors or inconsistencies, the total projected residual value  for these projects appeared to be overstated.
To determine the NMTC projects at risk of failing by becoming  economically nonviable, we analyzed data reported by CDEs to the CDFI  Fund that could indicate that a project is experiencing financial distress.  We used indicators of financial distress that are available from CDFI Fund  data, such as whether a loan on a project is delinquent, charged off, or  restructured that could show increased risk of business failure. These  indicators, in most cases, could not be used to conclude that a business  has failed in the sense of being economically nonviable as the CDFI Fund  does not currently have data on the ultimate disposition of NMTC  projects. We analyzed the number of projects that showed indications of  financial distress between 2003 and 2012, and the dollar amounts  invested in these financially distressed projects. We tested the reliability  of these optional fields by reviewing CDEs applications for 2012 NMTC  allocations. In the application instructions, CDEs were asked to discuss  any delinquent, defaulted, or impaired loans or equity investments from  prior NMTC investments. In the 2012 applications, we counted 281  projects with delinquent, defaulted, or impaired loans or investments. Of  these, 193 projects were described in sufficient detail that we could then  match those projects to transaction-level data in CIIS. However, 49 of  those projects did not show any indications of financial distress in CIIS.  For some projects involving multiple CDEs, one or more CDEs may have  described the project in their 2012 applications as having delinquent,  defaulted, or impaired investments, but only one CDE then reported any  of the optional distress indicator data in CIIS. In other cases, CDEs  described several projects in the 2012 applications as having delinquent,  defaulted, or impaired investments, but then those CDEs did not report  any distress indicators for these projects in CIIS. In the end, we  concluded that the CDFI Fund CIIS data on indicators of financial distress  were insufficient for our purposes, largely due to the fact that nearly all of  the distress indicators were optional data fields.
We conducted this performance audit from May 2013 to July 2014 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
section_title: Appendix II: Other Federal Funding Used in New Markets Tax Credit Projects
paragraphs: In our survey of New Markets Tax Credit (NMTC) projects, we asked  Community Development Entities (CDEs) what other federal sources of  assistance were used (in addition to the NMTC) to fund the project.  CDEs could select from a pre-populated list of federal sources comprised  of federal tax credits, public bond financing exempt from federal tax,  grants or direct payments from federal agencies, and direct or guaranteed  loans from federal agencies. Our survey also permitted CDEs to write in  other federal sources not included in the pre-populated list. CDEs were  also asked if the NMTC was “twinned” or “enhanced” with any of these  federal sources inside the NMTC structure, i.e., did NMTC investors claim  NMTCs based on these additional amounts of federal assistance. The  NMTC investor community often refers to this practice as “twinning” the  NMTC with other tax credits or other public assistance, but for purposes  of this report, we define this as leveraging other public sources with the  NMTC. The four tables below list the types of other federal assistance  (from our pre-populated list of federal assistance and write-in  descriptions) that CDEs reported as being used to finance our sample of  NMTC projects, and whether these other federal sources were leveraged  with the NMTC.
section_title: Appendix III: Regression Analysis of Total Fees and Retentions Associated with Characteristics of the Project Using CDFI Fund Data, 2011-2012
paragraphs: Dollar amount of NMTC qualified equity investment (QEI)
Number of transactions (financial structure complexity)
Poverty rate > 30% (distressed community)
The table reports the results of an ordinary least squares regression with  the dependent variable equal to the amount of fees and retentions  charged. Omitted category variables are: project type equal to  “rehabilitation or other” and origination year equal to “2011.” The  regression was also estimated using various functional forms including  quadratic and log forms of the regression equation. These specifications  either were rejected as statistically insignificant or, in the case of some of  the log specifications, resulted in a substantial decrease in the  explanatory power of the regression as measured by its R-squared.
This regression was also estimated with fees and retentions as separate  dependent variables, and, in these cases, the results were different for  certain variables of interest. With fees as the dependent variable, neither  the interest rate nor the number of transactions was statistically significant  at the 95 percent confidence level. However, the size of the qualified  equity investment remained positive and significant. With retentions as  the dependent variable, the retentions were positively and significantly  related to interest rates but had no statistically significant relationship to  the number of transactions.
section_title: Appendix IV: Comments from the Department of the Treasury
section_title: Appendix V: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
paragraphs: James R. White, (202) 512-9110, or whitej@gao.gov.
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Kevin Daly, Assistant Director;  Amy Bowser; Cathy Hurley; Mark Kehoe; Jill Lacey; Edward Nannenhorn;  Mark Ramage; Wayne Turowski; and Elwood White made key  contributions to this report.
section_title: Related GAO Products
paragraphs: 2014 Annual Report: Additional Opportunities to Reduce Fragmentation,  Overlap, and Duplication and Achieve Other Financial Benefits.   GAO-14-343SP. Washington, D.C.: April 8, 2014.
Community Development: Limited Information on the Use and  Effectiveness of Tax Expenditures Could Be Mitigated through  Congressional Attention. GAO-12-262. Washington, D.C.: February 29,  2012.
Efficiency and Effectiveness of Fragmented Economic Development  Programs Are Unclear. GAO-11-477R. Washington, D.C.: May 19, 2011.
Opportunities to Reduce Potential Duplication in Government Programs,  Save Tax Dollars, and Enhance Revenue. GAO-11-318SP. Washington,  D.C.: March 1, 2011.
New Markets Tax Credit: The Credit Helps Fund a Variety of Projects in  Low-Income Communities, but Could Be Simplified. GAO-10-334.  Washington, D.C.: January 29, 2010.
HUD and Treasury Programs: More Information on Leverage Measures’  Accuracy and Linkage to Program Goals Is Needed in Assessing  Performance. GAO-08-136. Washington, D.C.: January 18, 2008.
Tax Policy: New Markets Tax Credit Appears to Increase Investment by  Investors in Low-Income Communities, but Opportunities Exist to Better  Monitor Compliance. GAO-07-296. Washington, D.C.: January 31, 2007.
New Markets Tax Credit Program: Progress Made in Implementation, but  Further Actions Needed to Monitor Compliance. GAO-04-326.  Washington, D.C.: January 30, 2004.