Review Group - Paper 3
REVIEW OF THE LEGISLATIVE PROVISIONS FOR LOCAL AUTHORITY BORROWING
PRUDENT PROVISION FOR THE REPAYMENT OF DEBT
Background – English provisions
1.
In England the statutory provision for the repayment of debt is known as
Minimum Revenue Provision. (MRP). In 2008 the UK Government revised their
legislation and replaced the detailed rules as to calculation of the amount which is
required to be charged each year with a simple duty for an authority each year to make
an amount of MRP which it considers to be “prudent”.
2.
The UK Government has also issued statutory guidance on MRP. The
guidance has three main topics (1) Annual MRP Statement, (2) Meaning of “Prudent
Provision”, and (3) Options for Prudent Provision.
Annual MRP Statement
3.
The UK Government (Secretary of State) recommends that before the start of
each financial year a local authority prepares a statement of its policy on making MRP
in respect of that financial year and submits it to the full council. For authorities without
a full council, approval of the statement should be at the closest equivalent level. The
statement should indicate how it is proposed to discharge the duty to make prudent
MRP in the financial year. If it is ever proposed to vary the terms of the original
statement during the year, a revised statement should be put to the council at that
time.
Meaning of Prudent Provision
4.
The English guidance identifies that “The broad aim of prudent provision is to
ensure that debt is repaid over a period that is either reasonably commensurate with
that over which the capital expenditure provides benefits, or, in the case of borrowing
supported by Government Revenue Support Grant, reasonably commensurate with the
period implicit in the determination of that grant.”
5.
The UK Guidance then identifies the methods of making prudent provision,
advising that approaches differing from those exemplified are not ruled out.
Options for Prudent Provision
6. Four options are identified in the English guidance:
a. Option 1 – Regulatory method
b. Option 2 – CFR method
c. Option 3 – Asset Life Method either (i) Equal instalment method or
(ii) annuity method
d. Option 4 – Depreciation Method
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7.
The guidance advises that options 1 and 2 may only be used in relation to
capital expenditure incurred before 1 April 2008 and any new expenditure where the
borrowing is supported by the Government through the payment of grant. Options 3
and 4 are for all new self-financed borrowing.
Option 1 - Regulatory Method
8.
The regulatory method is where MRP is equal to the amount determined in
accordance with the former English regulations. This calculation was based on
percentages of a ‘credit ceiling’ and the system under which the UK Government
calculated the amount of revenue grant provided to support debt.
Option 2 - CFR Method
9.
The CFR method uses the Prudential Code’s ‘Capital Financing Requirement’.
MRP is equal to 4% of the non-housing CFR at the end of the preceding financial year.
Option 3 - Asset Life Method
10.
For new borrowing under the Prudential system for which no Government
support is given and is therefore self-financed, there are two options in the guidance.
11.
The first of these is the equal instalment method, which results in a series of
equal annual amounts over the estimated life of the asset. The calculation to be made
is set out in a formula in the guidance.
12.
The second option is the annuity method, which has the advantage of linking
MRP to the flow of benefits from an asset where the benefits are expected to increase
in later years. A local authority is required to use an appropriate interest rate to
calculate the amount. MRP is the principal element for the year of the annuity required
to repay over the asset life.
Option 4 – Depreciation Method
13.
MRP is equal to the provision required in accordance with depreciation
accounting in respect of the asset on which expenditure has been financed by
borrowing. This should include any amount for impairment chargeable to the
Comprehensive Income and Expenditure Account.
Other options
14.
The English guidance advises that the four options included in the guidance are
those likely to be most relevant for the majority of authorities. Other approaches are
not ruled out but they must be fully consistent with the statutory duty to make prudent
revenue provision. Other approaches could include taking account of local
circumstances, including specific project timetables and revenue-earning profiles.
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Scottish context
Government supported debt
15.
The English Options 1 and 2 reflect the historic calculation of English MRP and
reflects UK Government support for English local authority borrowing in the past. With
the exception of new capital expenditure with the borrowing funded from Government
support, these two options are to allow borrowing prior to 2008 to continue to be
calculated on the same basis i.e. a transition provision.
16.
The calculation of Scottish Government supported local authority borrowing has
taken various forms over the years but Scottish local authorities have never been
required to match the Scottish Government support to the actual loan fund advances
made by Scottish authorities.
17.
As a transition arrangement a prudent provision for the repayment of a loan
fund advance made prior to 1 April 2015 should include a continuation of the
repayment of historic debt as calculated under paragraph 17 of schedule 3 of The
Local Government (Scotland) Act 1975.
Self-financed borrowing
18.
The English option 3 reflects the current Scottish approach. Paragraph 15 of
schedule 3 to the 1975 Act requires all loan fund advances to be repaid in equal
instalments of principal or by annuity. The period of the repayment is aligned to a
proxy asset life as set out by Finance circular 29/1975. This is known as the “fixed”
period in the 1975 legislation.
19.
The English equal instalment method is calculated by the formula
MRP is the amount given by the following formula:
A–B
C
whereA is the amount of the capital expenditure in respect of the asset financed by
borrowing or credit arrangements
B is the total provision made before the current financial year in respect of that
expenditure
C is the inclusive number of financial years from the current year to that in which
the estimated life of the asset expires.
20.
This will normally generate a series of equal annual amounts over the estimated
life of the asset. The original amount of expenditure (“A” in the formula) remains
constant. The cumulative total of the MRP made to date (“B” in the formula) will
increase each year. The outstanding period of the estimated life of the asset (“C” in the
formula) reduces by 1 each year. For example, if the life of the asset is originally
estimated at 25 years, then in the initial year when MRP is made, C will be equal to 25.
In the second year, C will be equal to 24, and so on.
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21.
The repayment of the borrowing normally commences in the financial year
following the one in which the expenditure is incurred. However, where the borrowing
is for an asset that is not yet operational, and authority may postpone beginning to
make MRP until the financial year following the one the asset becomes operational.
Operational takes its standard accounting definition.
22.
The estimated life of the asset is determined in the year the repayment of the
borrowing commences and is not subsequently revised, even if in reality the condition
of the asset changes that life significantly. If no life can reasonable be attributed to an
asset, such as freehold land, the life should be taken as a maximum of 50 years.
However, in the case of freehold land on which a building or other structure is
constructed, the life of the land may be treated as equal to that of the structure, where
this would exceed 50 years.
23.
The formula allows an authority to make voluntary extra provision in any year.
This will be reflected in amount B and will automatically ensure that in future years the
amount of provision determined by the formula is reduced.
24.
The English annuity method is offered as an alternative where the flow of
benefits from an asset are expected to increase in later years. The guidance suggests
this may be projects which promote regeneration or administrative efficiencies or
schemes where revenues will increase over time.
25.
The same rules for the repayment period (asset life) and the commencement of
the repayments also apply to the annuity method.
26.
27.
The differences between the Scottish statutory provision and the English
approach can be summarised as follows:
Scottish
The repayment period is based on
the periods set out in Finance
Circular 29/1975 (the fixed period)
The repayments commence within
12 months (or 6 months if half yearly
instalments) from the date of the loan
fund advance.
The Scottish legislation is silent on
whether voluntary extra provision
may be made
Finance Circular 29/1975 (the fixed
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English
The period of the repayment is
based on the life of the asset the
subject of the borrowing. Whilst not
stated it is assumed this reflects the
accounting policy for asset lives set
by the authority.
Repayments commence the financial
year
following
the
capital
expenditure. The exception is where
the new asset is not complete (not
operational). In this case repayment
commences in the financial year
following the year the asset becomes
operational. Called a “MRP holiday”
Identifies voluntary extra provision as
part of a prudent provision for the
repayment of borrowing.
Freehold land is attributed a life of 50
period) sets the repayment period for years Where there is a structure on
land as 60 years.
freehold land and this structure has a
life of greater than 50 years, the
same life estimate may be used for
the land.
For annuity the legislation mentions The statutory guidance identifies
interest as being part of the MRP as being the principal element
repayment.
for the year of the annuity.
The legislation is silent on the The statutory guidance requires an
interest rate to be used to calculate “appropriate”
interest
rate
to
the annuity.
calculate the annuity.
28.
The English option 4 is the depreciation method. MRP is equal to the provision
required in accordance with depreciation accounting in respect of the asset on which
expenditure has been financed by borrowing. This should include any amount for
impairment chargeable to the Comprehensive Income and Expenditure Account.
Standard depreciation accounting should be followed, except in the following respects:
a. MRP should continue to be made annually until the cumulative amount of
such provision is equal to the expenditure originally financed by borrowing or
credit arrangements. Thereafter the authority may cease to make MRP.
b. On disposal of the asset, the charge should continue in accordance with the
depreciation schedule as if the disposal had not taken place.
c. Where the percentage of the expenditure on the asset financed by borrowing
or credit arrangements is less than 100%, MRP should be equal to the same
percentage of the provision required under depreciation accounting.
29.
There is currently no equivalent provision in Scotland.
30.
The pattern of annual depreciation charges for a fixed asset should attempt to
match the pattern of benefits derived from that asset. Therefore, where the benefits
from an asset are likely to be reasonably constant over its life the straight-line method
of depreciation would be appropriate as it results in a constant annual depreciation
charge. In practice it may be difficult to assess the pattern of benefits relating to an
asset. In such cases the straight-line method may often be chosen simply because it is
easy to understand and calculate. For certain fixed assets, the benefits derived may be
high in the early years, but may decline as the asset ages. For such assets, the
reducing-balance method of depreciation would be appropriate insofar as it matches
the depreciation expense with the pattern of benefits.
31.
Straight-line depreciation is calculated by taking the purchase or acquisition
price of an asset, subtracting the residual value (value at which it can be sold once the
body no longer needs it) and dividing by the asset life i.e. (Cost of asset - Residual
value) / Expected life. In this respect it is similar to the equal instalment method with
the value of the instalments being reduced to reflect the residual value. Any
impairment is however an immediate charge to the General Fund.
32.
The reducing balance method is considered for any asset that has a high
usage in the early part of its life. The reducing balance method reduces the value of an
asset by the same percentage each year. The percentage to be used is calculated by
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a formula. Relatively heavy charges in depreciation are incurred during the earlier
periods of the life and lighter charges in the later periods. The advantage of this
method is that increasing maintenance and repair charges for plant and machinery can
be offset against the decreasing depreciation charges.
Revenue earning capital projects
33.
The English guidance permits other options, individually designed for specific
capital projects, if this is fully consistent with the statutory duty to make prudent
provision. The guidance indicates that a different approach may be considered for
projects with a revenue-earning profile.
Tax Incremental Financing (TIF)
34.
The Scottish Ministers have agreed a number of pilot Tax Incremental Financing
(TIF) projects.
35.
Tax increment financing (TIF) is a method of financing the public costs
associated with a private development project. Essentially, the property tax increases
resulting from development are targeted to repay the public infrastructure investment
required by a project. TIF provides a means of encouraging private investment by
allowing a local authority to retain the increased (incremental) future Non Domestic
Rates (NDR) tax revenues to finance the current infrastructure costs needed to attract
development.
36.
The TIF pilots demonstrate that, whilst future incremental NDR (known as TIF
Revenue) is sufficient to finance the TIF debt costs over the life of the TIF (for pilot
projects this was set at 25 years), there is often an early years funding gap. This
funding gap occurs in the early years when a council has borrowing costs to finance
but the TIF revenue has not yet commenced.
37.
A prudent provision for the repayment of borrowing for TIF projects could be to
profile the TIF project repayments of debt principal to match the TIF revenue. Where
TIF Revenue is insufficient to repay the debt principal over the 25-year period, the
balance outstanding at year 25 could be repaid over the remaining asset life applying
an alternate option.
City Deal
38.
The nature of a City Deal may see a capital investment spend profile that does
not match the profile of the funding commitment from national government. City Deal
councils will borrow to fund the early capital investment not matched by grant, using
future government grant to repay that debt principal. City Deal councils seek the ability
to design a profile for the repayment of debt principal (loan fund advance) which can
be matched to the grant funding profile.
39.
A prudent provision for the repayment of City Deal borrowing could be profile
the repayment of debt principal to match the profile of future government grant.
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Town and Country Planning (Scotland) Act 1997 - Section 75 Planning
Obligations
40.
Similar to TIF projects, a local authority is often required to undertake public
infrastructure investment to support a private development project. Where this is
required to mitigate the impact of a development, then the authority would in effect
front-fund the infrastructure and recoup its cost from the developer over time. An
important factor however is the timing of the repayments and whether these can be
delayed long enough for the developer to deliver units on the ground and receive a
return, in order to repay the Council. A straight-line depreciation may therefore be less
appropriate than say linking the repayment to triggers in the planning consent and
related section 75 agreement, such as the completion or occupation of x units.
41.
We would therefore wish to explore with the review group what a prudent
provision for the repayment of debt principal could be for capital investment linked to a
section 75 planning obligation.
Conclusion
42.
It appears that an option for Scotland for the prudent provision for the
repayment of borrowing should include a revenue matching option.
Consent to borrow
43.
There is no proposal to change the legislative provision for Scottish Minister’s
consent for a local authority to borrow for purposes other than those currently set out in
paragraph 1 of Schedule 3 of the Act of 1975.
44.
Scottish Ministers will therefore retain the right to provide consent on such terms
and conditions as to repayment they consider appropriate. However, in setting those
terms and conditions, it would be appropriate for them to reflect the same principles
agreed for a “prudent provision”.
Recommendation
45.
To consider what should constitute a prudent approach to the repayment of debt
principal, and the meaning of “prudent provision” for Scottish local authorities.
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