By Dr. Straton Makundi

Introduction

The banking sector in Tanzania plays a major role in economic growth and financial stability. This is through provision of various services including loan issuance to businesses and individuals. To ensure financial health and risk management, central banks and accounting standards require banks to set loan loss provisions for potential losses from loan defaults. These provisions ensure that banks maintain adequate buffers to manage defaults without affecting operations which also increases investors’ confidence.

Banks in Tanzania are required to align their loan loss provisions accounting with IFRS 9 Financial Instruments using the Expected Credit Loss Model (ECL). The model requires loan loss provisions to be based on historical and forward-looking information. However, tax authorities are concerned that loan loss provisions can lead to reduction of taxable income thus lower tax revenues. They assert that loan loss provisioning is partly not based on actual losses, thus immediate deductions imply loss of revenue on income which the entity has not conclusively suffered a loss. This is because ECL models involve subjective judgment and assumptions. As a result, an expense deduction for loan loss provisioning is only allowed when there is strict adherence to the provision of section 25 of the Income Tax Act, 2004. This tax provision requires banks to demonstrate that all reasonable steps have been taken to recover the debt and compliance with the regulatory standards established by the Bank of Tanzania. There is also a requirement for actual write off of the bad debt in the entity’s book. Several recent Court of Appeal tax cases involving banks in Tanzania have upheld the position of the Income Tax, 2004.

Challenges for Banks

Due to the requirements of the Income Tax Act, 2004, banks must keep extensive documentation evidencing loan recovery efforts to get approval of the loan loss provision expense deduction for tax purposes. In the absence of the documentation, there is a risk of increased tax liability due to higher taxable income thus affecting the bank’s cash flow as well as its ability to lend through reduction of its capital.

Further, the lack of alignment between the Income Tax Act, 2004 and accounting rules (IFRS 9) has led into protracted tax disputes and prolonged tax audits. This is due to the TRA questioning of the assumptions and estimates used in IFRS 9 ECL model computation in terms of alignment with section 25 of the Income Tax Act, 2004.

A Need for a Balanced Approach

To ensure a progressive tax system, there is a need to review the current tax deductibility rules for banks’ loan loss provisioning to align with global trends and best practices. The review should cover the following:

            i)  Alignment of the Income Tax Act, 2004 on loan loss provisioning with IFRS 9

There is a need to harmonize accounting and tax laws using a phased approach deductibility of loan loss provisions. This entails re-writing of section 25 of the Income Tax Act, 2004 to align with the expected credit losses to allow tax deductions related to the credit risk while maintaining some safeguards to ensure the Government does not loose tax revenue. A good example is South Africa, which has reformed its tax laws by allowing some deductions under stage 1 and 2 with some specific safeguards and anti-abuse measures. For instance, the South African Revenue Service (SARS) allows a minimum tax deductibility for stage 1 provisions as there is limited risk while partial deductions are allowed for stage 2 where there is increased significant risk. Full tax deductions are allowed under stage 3 due to actual impairment of non-performing loans.

The United Kingdom follows the same approach as South Africa i.e. deductibility of loan loss provision is based on IFRS 9. However, the tax authority, His Majesty Revenue and Customs (HMRC), requires robust evidence and undertake a thorough review of the ECL model to detect inflated deduction claims.

          ii)  Standardized documentation and Digital Reporting Platform:

There is also a need to develop a standardized documentation to support recoverability efforts. TRA can work with the Tanzania Bankers Association (TBA) to develop a digital platform for reporting and documentation. This will address the administrative burden and simplify the TRA tax audit process.

Dr. Makundi is a Partner with Auditax International