The Seventh Schedule of the Finance Bill 2010 in respect of classified advances and off-balance sheet items allowed subject to maximum threshold Rule 1(c). The Seventh Schedule was introduced through the Finance Act, 2007. However, it was made applicable from the tax year 2009 (financial year beginning 1 January 2008).
The rationale behind introducing this specific Schedule was to provide special provisions for taxation of income of banking companies like those available to companies involved in the business of insurance and petroleum exploration.
The original version of the Seventh Schedule, when enacted, carried the following provisions for the tax treatment of non-performing loans, which in the past had always given rise to contentious issues between the tax department and the banking companies.
The said provisions contained in Rule 1 of the Schedule were to the following effect:
(a) provisions for classified advances and off-balance sheet items claimed in the accounts are allowable on the basis of a certificate from the external auditors to the effect that such provisions are in accordance with the Prudential Regulations issued by the State Bank of Pakistan (SBP);
(b) irrecoverable debt, classified as 'substandard' in accordance with the Prudential Regulations is not to be allowed;
(c) a 'substandard' irrecoverable debt is eligible for deduction upon its subsequent classification as 'doubtful' or 'loss' under the Prudential Regulations; and
(d) an item classified as 'substandard' and having been taxed in a previous tax year, subsequently reclassified as 'recoverable', also qualifies for deduction.
The above provisions laid to rest the major issue faced by banking companies for claiming their doubtful debts as an allowable deduction primarily on account of the fact that it was based on the SBP's Prudential Regulations. However, certain issues of transitional provisions, like unabsorbed depreciation on assets given on lease by banks, and bad debts of prior years remained unresolved and, hence, were required to be addressed by appropriate amendments in the said Schedule.
Through the Finance Act, 2008 the provisions regarding allowability of non-performing loans was reversed and banks were asked to claim bad debts in accordance with section 29 and 29A of the Ordinance.
The Finance Act, 2009 partially came to the rescue of the banking companies whereby the claim of bad debts as per the Prudential Regulation was restored. However, such restoration was with the restriction in the form of a cap on the allowable provision for bad debt @ 1 percent of total advances.
Further, issues of prior year bad debts reclaim and carry forward of unabsorbed depreciation of leased assets that pertain to tax years 2008 and earlier were not addressed.
The Bill now seeks to partially address the issue of restriction of claim of bad debts as well as introducing the necessary transitional provisions. It is now proposed that apart from the 1 percent cap on allowability of provisions for advances, provisions for advances for consumer and small and medium enterprises (SMEs) would be allowed at 5 percent of total advances for consumers and SMEs.
69. Transitional provisions
Rule 8A
Further transitional provisions for allowability of reclaim of prior year bad debts for tax years up to 2008 have been proposed. Any recovery and consequent write back in the tax year 2009 and thereafter in any tax year which is credited to the profit and loss account would be excluded in computing the income of that tax year. Further, assets given on finance lease up to tax year 2008 would be allowed in a manner as if the seventh schedule has not come into force. Accordingly, unabsorbed depreciation in respect of such assets shall be allowed to be set off against the corresponding lease rental income.
Although most of the issues encountered by the banking industry have substantially been addressed by the Bill, the issue of capping for purposes of deductibility, the overall provision for non-performing loans at 1 percent of total advances, other than consumers and SMEs, remain unresolved.
In view of the facilitating inclination of the Board towards resolution of significant tax issues faced by the banking companies, particularly in the wake of global and domestic economic upheaval, it would not be unreasonable to expect that the aforesaid issue will also be settled in right earnest with due appreciation of the ground realities and the business imperatives of the banking companies which have sought the capping at 2 percent.