by João Sérgio Ribeiro, Professor of Tax Law, UMinho
The tax treatment of bank loan losses has been a controversial issue. Banks generally want tax rules recognising loan losses to conform in a close manner to regulatory accounting, in order to obtain tax benefits from loss provisioning. Tax officials, on the other hand, often fear that accepting said close conformity for tax purposes will dramatically reduce corporate tax paid by banks.
Loan losses represent inevitable costs that banks have to bear in order to generate income. Therefore, these losses should be accepted as an expense for both tax and financial purposes. The fundamental question is, at the end of the day, when and how non-performing loan losses should be recognized as an expense for tax purposes.
Now, with the Covid-19 crisis and the most certain upsurge of non-performing loans, the topic gains added relevance. The tax treatment of non-performing loans varies greatly around the world, and the European Union is not an exception.
It is true that the treatment of loan losses is a sensitive tax policy issue. However, at the European level, Member-States should seek harmonization, otherwise distortions will be maximised to an unprecedented level.
By giving an overview of the topic we hope to create awareness of how urgent is to move to harmonization in terms of the tax treatment that Member-States avail to non-performing loans.
Tax treatment of non-performing loans
The tax treatment of loan losses varies widely amongst countries and most often there is a lack of correspondence between accounting rules and tax rules, which combined with equity, profitability and bank ratings concerns, may foster under-provisioning.
Some countries only allow the charge-off method or write-off, under which loan losses are only accepted when loans become unpayable. That is, a loan is written-off when the bank no longer expects the loan payment to be fulfilled. In determining whether a loan is unpayable, all relevant data, such as ongoing non-performance and the financial condition of the debtor should be taken into account. Under this method, if an amount previously written off as impossible to charge is, later on, recovered or loan payments are resumed, the amount previously written off becomes income again.
Many other countries, though, accept a reserve method (provisioning) in order to account for loan losses for tax purposes, in addition to requiring it for regulatory purposes. However, only a few countries manage to ensure a full conformity between tax and financial accounting for loan losses.
Other countries (e.g., United Kingdom, France, Germany) allow tax deductibility to specific allowances or charge-offs in the year they materialise, but not for allowances of general nature.
Finally, a few countries allow general provisioning for tax purposes (e.g., based on a percentage of eligible loans), but limit the scope of general provisioning. Germany, for instance, requires that the general provision for tax purposes does not exceed 60 percent of average loan losses, over the past five years.
Charge-off vs. Reserve Methods
Both the charge-off and reserve methods acknowledge that bad debts are costs necessary to generate income, and, as a consequence, these costs should be accepted as deductible expenses for financial and tax purposes. In general, the reserve method speeds up the recognition of the expense, if compared with the charge-off method. In fact, depending on the bankruptcy legal framework and court approaches, the charge-off delays in some jurisdictions could be unlimited, in the sense that bad debts should be charged off for tax purposes in the year they are classified as uncollectible for regulatory purposes.
High conformity between financial and tax accounting
An important advantage of having a high level of conformity between loan loss provisioning for financial and tax purposes is that tax authorities would not have to determine how reasonable the provision would be. The outcome would be that banks would benefit from a greater certainty which would reduce disputes between those banks and tax authorities. Nevertheless, a high level of conformity does not necessarily imply full conformity. Administrative simplification would still be attained if only a certain number of provisions would be deductible for tax purposes.
Conformity between financial and tax accounting for loan losses would also guarantee that the tax system does not discourage banks from making adequate provisions for loan losses.
Low conformity between financial and tax accounting
Financial accounting is based on conservatism. As a result, it tends to delay income recognition and, conversely, to anticipate expenses and losses.
Conversely, the objective of tax accounting is to make sure that income is not understated. Therefore, income is taxed as soon as it flows to the taxpayer. Hence, it would be normal to impose tax on prepayments of rent as soon as they are received, regardless of the fact that they may relate to a period that goes beyond the fiscal year.
Even though general reserves aim at present or latent losses, they are intrinsically speculative, and allow margin for free judgement by bank managers. This feature coupled with the tax accounting rule, according to which, a liability should not be acknowledged for tax purposes until it becomes certain and, therefore, suitable to be estimated, may create problems. Moreover, recognizing general provisions for tax purposes can be very costly, in the sense that, for banks, those general provisions are larger than their specific provisions. It is not surprising, though, that tax authorities show reluctance to allow banks to deduct general reserves for unidentified, but, supposedly, present losses.
Tax officials have prejudice against specific reserves because they think they are set on the high side to be conservative, to protect the banks’ capital, and to reduce effectively risky behaviours.
Tax authorities, want, however, to make sure that banks do not overstate reserves. For that to happen, they advocate that regulatory reserves, if allowed for tax purposes, should be maximums rather than minimums.
As we hope to have demonstrated, there is wide diversity of tax treatment options for non-performing loans. This reality, combined with the fact that there is no generally accepted international standard as to the appropriate tax treatment of loan losses, creates legal insecurity for banks operating internationally and undesired distortions which pose high risks. Especially in the context of the European Union where Banking Union and harmonisation in the field of direct taxation is sought. That is why urgent action to tackle more efficiently the Covid-19 crisis effects on the banking system is needed. Not to mention that effects on banks are unfortunately very often transferred to taxpayers as those effects may impact severely public finances.
Pictures credits: House construction by pxfuel.