Liability Servicing Limits

Section 174 of the Community Charter "Limit on borrowing and other liabilities" provides authority for Cabinet to limit either the aggregate liabilities of a municipality, or the annual cost of servicing the aggregate liabilities and for a method for determining that limit. BC Regulation 254/2004 (Municipal Liabilities Regulation) limits the annual cost of servicing certain defined liabilities.
 

The annual cost of servicing liabilities (referred to as "liability servicing cost") is the total of the average actual principal and interest charges on defined liabilities, where expenditures in relation to those liabilities are being made, plus the total of the average "implied" costs for all defined liabilities that are not yet realized.
 

The use of an annual liability servicing limit has been chosen as the limitation model because it provides a clear picture of the amounts of revenue required to pay for past transactions and events as well as proposed liabilities, which will assist in the financial planning process. The limit is based on a percentage of certain municipal revenues, which is considered a good indicator of a municipality’s ability to pay.
 

The maximum value of liability servicing cost for a given year is 25% of a municipality’s controllable and sustainable revenues for the previous year. Section 174 also provides the authority for a municipality to exceed this limit with the approval of the Inspector of Municipalities. Guidelines and policies for this approval are currently being developed in consultation with the Municipal Finance Authority.
 

What is required

Therefore, each time a defined liability is proposed, the Financial Officer must determine whether the servicing costs for the proposed liability, when added to all other annual servicing costs for defined liabilities, will exceed the annual liability servicing limit established for that year. For this purpose, a statutory declaration is required whenever a loan authorization bylaw is submitted to the Ministry for approval or a leasing request is submitted to the Municipal Finance Authority. This declaration states the extent of total liabilities outstanding and the related annual servicing cost, along with certification that the municipality has not exceeded its annual liability servicing limit.
 

Whether or not the liability to be incurred is one for which a statutory declaration is required, the Financial Officer will want to consider these same issues. Given that the municipality is only authorized to incur liabilities up to the limit, it is important to ensure that the limit is not exceeded. Exceeding the limit without seeking prior approval of the Inspector could leave the municipality open to a Courts challenge that it did not have the authority to incur the liability.
 

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What to consider

Examples include:

• municipal property taxes, (with limitations on class 4), parcel taxes, local service taxes, 1% utility tax
• payments in place of taxes
• fees and charges, except for development cost charges
• provincial unconditional transfers (small community grant, traffic fine revenue sharing grant and ports competitiveness grant)
• gaming revenues
• tax sharing revenue received
• interest on investments
• rent, building permits, franchise fees, fines etc earned in the usual course of business

The amount of Class 4 (Major Industry) revenue that may be included in revenue calculations for the purpose of a municipality’s limit may be less than actual revenue received from this source. This limitation recognizes that Class 4 taxation revenue represents greater risk than other taxation revenue. Both assessed values and tax rates may be adjusted for Class 4 revenue. Class 4 assessed value is limited to 20% of the total assessed value of all properties in the municipality, and the class 4 general municipal tax rate is limited to the provincial average. Class 4 revenues are also adjusted to take tax sharing agreements into consideration, if applicable.
 

The calculation to determine the amount of class 4 tax revenue to be included in the liability servicing calculation is obtained by multiplying the lesser of the class 4 assessed value and 20% of the total assessed value by the lesser of the local government’s class 4 tax rate and the provincial average class 4 tax rate. In the case of tax sharing municipalities, the assessment and the tax rate must be derived, taking into account the amount received or paid. A municipality which pays tax revenue to another municipality will deduct the corresponding assessed value from both class 4 and from the total assessment, while the receiving municipality adds this same amount to its total.
 

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Liabilities
Liability servicing cost includes the average of the total principal and interest payments that are paid on capital commitments or guarantees plus amounts that represent the average principal portion of a contingency. Included in the calculation are:

• principal and interest payments for long-term debt
• principal and interest payments for short term capital borrowing
• the amount that would be paid if authorized but unissued debt were issued
• lease payments for capital leases
• payments under a capital agreement
• the amount that would be payable if capital contingencies or guarantees were realized

Specifically excluded are:

• operating leases, or the portion of an agreement that relates to operating costs
• employment contracts
• temporary borrowing, and
• obligations of the regional district or for which the regional district is joint and severally liable

The exclusion of operating leases or operating costs under an agreement is a significant improvement over the previous liability limits, which captured any operating costs under an agreement if the agreement exceeded five years, or could, by exercising rights of renewal or extension, exceed five years.
 

The amount of liability servicing costs will be easy to determine for most liabilities. For example, in the case of MFA debt, the liability servicing cost will be the total amount of principal and interest on the debt divided by the term of the debt. Similarly, liability servicing costs for short-term capital borrowing are the total principal and interest payments, divided by the term of the borrowing (typically five years). In the cases of capital leases, the liability servicing cost is the total of the lease payments divided by the term of the lease.
 

In some cases, liability servicing costs will need to be estimated. For example, in the case of authorized but unissued debt, principal and interest costs are estimated based on the current MFA interest rate for debt of the term authorized in the bylaw. In the case of a guarantee, liability servicing costs are estimated based on the total amount of the commitment that might be realized under the guarantee, divided by the number of years remaining in the guarantee.
 

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Where an agreement or other obligation combines both operating and capital components, as is typical in many public private partnership (P3) (361 KB) agreements, only servicing costs related to the capital portion of the agreement are included in the liability servicing cost limit. While this is an improvement over previous limits, which captured the operating portions of these agreements, it requires the Financial Officer to make estimates of the annual servicing costs under the agreement and apportion these costs to capital components (which are included in the limit) and operating components (which are excluded from the limit).
 

This determination is based on the substance of the agreement, rather than the form of the agreement. This "substance over form" parallels accounting standards, which require the same considerations in determining whether a lease is a capital lease or an operating lease. This means that the Financial Officer needs to look further than the form of liabilities arising out of the agreement, and consider the substance of the overall agreement in making these determinations (e.g., one cannot assume that a P3 agreement is entirely operating even if the only liability arising out of the agreement relates to annual revenue guarantees to the private sector partner).
 

For both leases and other forms of agreements, Financial Officers may wish to consider the following questions in deciding if an obligation should be included in the calculation:

• Can the agreement/contract be cancelled on favourable terms?
• Does the local government compensate for risk or bear some of the risk?
• Do guaranteed payment amounts over the life of the contract constitute the majority of the value of the asset being used?
• Is the local government required to, or does the local government have the option to, purchase the asset at some point in the future?

Answering "Yes" to any of these questions is a signal that there is a capital component to the obligation and that it should be included in the calculation of the liability servicing limit.
 

Professional accounting standards are of benefit in making some of these determinations. Further information can be found in the Canadian Institute of Chartered Accountants’ Handbook section 3860.18, Public Sector Guidelines 2 and 3 and in the Municipal Help Manual.
 

BC Regulation 254/2004 also provides some exemptions to the requirement that municipal loan authorization bylaws and liabilities under agreement receive elector approval.