Tax implications for banks of non-performing loans

The COVID-19 pandemic continues to cause serious health, business and lifestyle disruptions and challenges. As a result, some businesses have had to scale down their operations and some have had to close, and this has had ripple effects on other stakeholders such as financiers and employees. The Government of Kenya has put in place several measures to curb the spread of the virus such as curfews and health and safety protocols. At the time of writing this article, the spread of the virus is yet to be contained and the business community will need to invest more to ensure that they can continue to operate whilst observing the protocols laid down by the Government. In this environment, we have witnessed a number of supply chain disruptions. Many businesses face cash flow challenges as most had not planned reserves to withstand long interruptions of their operations. Some of the sectors that have been hardest hit include aviation, entertainment, hospitality, tourism, transport and logistics and education. The banking industry, which serves all sectors of the economy, has certainly been affected. Many individuals and businesses that had taken loans with financial institutions were unable to service them leading to higher loan default rates. In light of the hard economic times and in a bid to shield customers against the adverse effects of the COVID-19 pandemic, the Central Bank of Kenya (CBK) requested banks to restructure loan facilities to help cushion borrowers in a strained environment. Some of the measures that banks took include suspending the collection of either the principal loan amount or interest; reducing installment amounts payable or extending loan terms. In addition, the CBK required banks to meet the costs related to the extension and restructuring of the loans. The main focus has been on those borrowers who were unable to service the loans as a direct effect of the pandemic. Restructuring loan facilities has had far reaching effects for banks, as indicated by their interim results in the last quarter of 2020 so far. Non-Performing Loans (NPLs) have increased significantly which has forced most banks to increase their loan provisions in order to cushion against possible defaults. Unfortunately, the tax treatment of provisions for bad and doubtful debts under the Kenyan tax laws has not been aligned with the CBK prudential guidelines and International Financial Reporting Standards in order to shield banks from likely loan defaults. The Kenya Revenue Authority (KRA) is mandated to collect taxes from banks, but KRA's position seems to be inflexible in the context of banks' loan recovery challenges. In the wake of the COVID-19 pandemic, the KRA has sent out reminders to banks asking them to adhere to the guidelines regarding the tax treatment of bad and doubtful debts. The KRA’s guidelines on allowability of bad debts are very stringent and far removed from current business realities. Consequently, banks may be denied relief from the loans that they are unable to collect, leading to higher tax payment outflows. This will make a bad situation even worse. What steps can banks do to mitigate the risk of the provisions being disallowed? Banks need to be alive to the fact that any bad debt provisions and write-offs made during the pandemic and in the last five years (due to the statute of limitation) will be scrutinized by the revenue authority to confirm their allowability for tax purposes. Consequently, the banks may need to put in measures such as:

• Reviewing the provisions made in relation to their loan book and determine how these compare with the KRA’s guidelines;
• Where they intend to claim a tax deduction for their NPLs, ensure that they have adequate documentation to support the proposed tax treatment, and
• Undertaking a business review in order to understand the tax outflow impact and plan for it.

PwC's team of experienced tax professionals is ready and willing to assist banks with these and other options. Please contact us for further information.