Pakistan Banks' Association (PBA) has proposed amendments in the Seventh Schedule (Banking Schedule) of the Income Tax Ordinance 2001 to remove a major anomaly relating to carryover of charge for bad debts provisions on account of Consumer and Small and Medium Enterprises (SME) sector which resulted in adverse accounting implication for banks.
The proposed amendment in the Seventh Schedule of the Income Tax Ordinance 2001 requires that the provisions on account of consumers and SME loan should also be allowed to carried over to subsequent years if is in excess of five percent of the total portfolio. This would not have any revenue implications on the tax paid by the banks.
Sources told Business Recorder here on Thursday that the PBA has submitted a presentation to the Ministry of Finance and State Bank of Pakistan (SBP) to remove this lacuna in the Seventh Schedule of the Income Tax Ordinance 2001. According to the PBA, the anomaly is related to the carryover of charge for bad debts provisions on account of SME sector in a given year that has resulted in serious and adverse accounting implication for banks.
The PBA has further requested the Ministry of Finance to issue a policy statement before December 31, 2010 to the effect that the proposed amendments will be incorporated in the Income Tax Law and also to issue necessary instructions to the Federal Board of Revenue (FBR).
Details revealed that the Seventh Schedule to the Income Tax Ordinance, 2001 was introduced in 2007 primarily for the resolution of disputes related to charge for bad debts provisions. This law has seen frequent changes since its inception. The Finance Act, 2009 amended the Seventh Schedule and provided that tax relief for charge for bad debts provisions in any one year would be restricted to 1% of total advances at year-end. Any unabsorbed charge was allowed to be carried forward to succeeding years for set off against the 1% threshold of the related succeeding years.
The amendment translated in a position that the banks are required to pay tax to the FBR on the unabsorbed amount of charge for bad debts provision in the current year, whereas in accounts it was recorded as an expense. The accounting principles, however, permit that a deferred tax asset can be recorded by reducing the tax charge in the profit and loss account. This accounting treatment permits that tax charge for a particular year is equalised and there may not be abnormal fluctuation/distortions in the tax charge in the financial statements from year to year, PBA added.
In year 2010, the Finance Act further amended the Seventh Schedule whereby the threshold of 1% in respect of Consumer and SME sectors was enhanced to 5% of total advances. Whilst this tax relief has been allowed to the banks, however, no consequential change made in the last sentence of the said Rule 1 (c) to permit the banks to carry over the excess bad debt provision over 5% related to Consumer and SME sector as is the case for corporate sector loans. The threshold for corporate charge for debt provision remains at one percent of the related total advances at year-end.
Keeping in view legal position, the PBA, has proposed amendments in Rule 1 (c) of the Seventh Schedule of the Income Tax Ordinance 2001 to remove the anomaly. Under the existing provisions of the Seventh Schedule, the provisioning in excess of 1% would be allowed to be carried over to succeeding years. Provided that if provisioning is less than 1% of the advances, then actual provisioning for the year shall be allowed.
According to the proposed amendments in the Seventh Schedule, provisioning in excess of 1% and 5% as the case may be, would be allowed to be carried over to succeeding years. Provided that if provisioning is less than 1% and 5% as the case may be, of the total advances, then actual provisioning for the year shall be allowed.
The PBA further said that the proposed amendment allowing the banks to carry over would not result in any loss of revenue to the FBR since the banks would continue to pay taxes to FBR on the unabsorbed amount of charge for bad debts provisions in the given year. The industry average of the total advances in consumer and SME sectors is only 18% in 2008 and 2009.
The capping of 1% and 5% affects only a portion of the banking industry where the level of advances is moderate and are in a situation where there is an un-absorbed amount of debt charge for carry over. Although the law would permit the carry over, it is not necessary that the threshold amount of a subsequent year has the capacity to absorb the same, as such, the possibility of any significant loss of revenue to the exchequer is dismally remote.
Sources said that the major Pakistani banks have a large Advances portfolio and thus the capping at 1% or 5% does not create any tax issues for them, as they are able to have the provisions for bad debts fully allowed. On the other hand, foreign banks including foreign controlled banks do not get a level playing field since the advances portfolio is not large and the heavy consumer loans losses are not covered within the capping of 5 percent. Unfortunately, as the law is worded, such provision which is not allowed in the current year also cannot then be carried forward in such circumstances with regard to consumer loans. As such, any provision not allowed is taxed and at the same time cannot also be carried forward as the other large banks are able to.
To provide a level playing field and cater the law to provide relief in such cases, the required amendment is urgently required. Otherwise, banks such as the ones cited above would end up paying tax on income not earned. This does not augur well for the foreign banks and would affect the investment climate in Pakistan.
While the sustained and long-term growth of the SME sector in Pakistan remains constrained by a number of factors that include skills shortage, scarcity of capital goods, poor management, lack of data on the sector, resistance to change and marketing difficulties especially for export-oriented SMEs; by far the biggest problem facing the sector is the unavailability of adequate financing facilities.
The PBA further said that the government and the regulatory agencies such as the State Bank of Pakistan need to provide a conducive and enabling environment for SMEs to operate. This requires that the macroeconomic policies are sound and the legal and regulatory regimes are supportive. There ought to be a level playing field for both the small and large entrepreneur and that there is no preferential treatment for any particular category small or large-in the economy.
The current tax laws are creating a differentiation and putting SME at a disadvantage as banks would shy away from financing SME's in view of the fact that credit losses would not be fully tax deductible. There is, therefore, a need to give at "par" treatment to SME's for tax purposes by allowing the banks to carry over provisioning in excess of 5% to the succeeding years.
In view of the said position, the PBA requested that a policy statement is issued before the year ending on December 31, 2010 to the effect that the aforesaid amendments in the Seventh Schedule would be made and necessary instructions are issued to the FBR for bringing changes in the income tax law, PBA added.