TAX UPDATE: COURT OF APPEAL DECIDES ON THE FATE OF ‘BAD DEBTS’ AFFECTING THE TAXATION OF BANKS AND FINANCIAL INSTITUTIONS SUBJECT TO CERTAIN CONDITIONS

• Deductions of bad debt by Banks and financial institutions are determined in accordance with the relevant conditions provided by the Bank of Tanzania (BOT).
• All reasonable steps in pursuing payment must be taken and the Banks and financial institutions must reasonably believe that the debt claim will not be satisfied.
• The debt amount by the Bank/financial institution must have been included in calculating the Bank’s/financial institution’s income for the year of income.
• The debt must have been written off as irrecoverable in the books of accounts of the Bank/financial institution for that year of income in which the debt is claimed to have become bad.
• It goes without saying that, the procedure set for Banks and financial institution to finally be allowed to deduct bad debts after “exhausting all measures” is cumbersome since the process is long.

1.0 Introduction

On 9^th July, 2018 the Court of Appeal of Tanzania (His Lordship the Chief Justice Ibrahim Juma, Justice A.G. Mwarija and Justice R.E.S Mziray) sitting at Dodoma rendered a key decision which determines the treatment of bad debts by banks and financial institutions in Tanzania. The decision was made in the case of National Bank of Commerce v. Commissioner General (TRA), Civil Appeal No. 52 of 2018. The tax department at Breakthrough Attorneys analyzes the decision in line with compliance on income tax in Tanzania.

2.0 Legislation Under Focus

• The Income Tax Act, 2004 [Cap 332] (Income Tax Act)
• Finance Act, 2014

3.0 Treatment of “Bad Debts” as per the Income Tax, 2004

When calculating income, Section 25 (5) (a) & (b) of the Income Tax Act allows bad debts incurred by banks and financial institutions to be written off in the profit and loss account subject to fulfillment of certain conditions laid therein:
The conditions provided under Section 25 (5) (a) & (b) of the Income Tax Act (after amendment made by the Finance Act, 2014) are:

• That, such bank or financial institution should demonstrate that all reasonable steps have been taken to pursue payment; and,
• That, there is a reasonable belief that the debt claim will not be satisfied.

4.0 Controversy on treatment of bad debts

In the case of National Bank of Commerce v. Commissioner General (TRA), Civil Appeal No. 52 of 2018, the appellant Bank submitted that the Commissioner General (TRA) had a narrow interpretation of Section 25 of the Income Tax Act in which permitted bad debts incurred by the Bank to be written off.

The Bank argued that, TRA denied to write off bad debts occurred by the Bank despite the fact that the Bank  had complied with the accounting principles and Banking and Financial Institutions Act 2006 [Cap 42] and the Banking and Financial Institutions (Management of Risk Assets) Regulations 2008 (GN No. 374/2008) (BOT Regulations). Below are stages that the tax dispute passed before it reached the Court of Appeal of Tanzania;

4.1 Earlier decision of the Commissioner General (TRA)

The Commissioner General (TRA) made final assessments (Nos. F42015050555, F420150547 and F420150227) demanding the Bank payment of total amount of TZS 4,749,673,077.00 as income tax subject to the Bank for the years of income 2005, 2006 and 2007 respectively. The Bank appealed to the Tax Revenue Appeals’ Board (the Board), then to the Tax Revenue Appeals’ Tribunal (the Tribunal) without a success and consequently appealed to the Court of Appeal of Tanzania (CAT).

4.2 Decisions of the Board

The Board dismissed the Bank’s appeal and ruled in favor of TRA. The Board held that, the provisions for impairment of bad debts is permissible under law but only when the debts have been actualized and all debts have been realized as well as written off from the books of accounts after all recovery mechanisms have failed. Aggrieved by the decision of the Board, the Bank appealed to the Tax Revenue Appeals Tribunal.

4.3 Decisions of the Tribunal

The Tribunal also dismissed the appeal by the Bank. The Tribunal determined that, the Bank had not shown that its debt had been written off from its books of accounts, which is one of the two conditions before the Bank could rely on section 25(5) of the Income Tax Act. In a nutshell, the Tribunal held that the appellant could not rely on the deductions. Still determined, the Bank referred an appeal to the Court of Appeal of Tanzania.

4.4 Decision of the Court of Appeal of Tanzania (CAT).

The CAT dismissed the Bank’s appeal. The CAT said that the main area of contention between the Bank and the TRA was premised on which provision of the Income Tax Act are applicable to the deductibility of the Bank’s impairment provisions; that is between section 25(5) of the Income Tax Act on one hand, and sections 18(b) and 39(d) of the Income Tax Act on the other hand.

The CAT held that, in interpretation of statutes it is bound to apply the plain language of a statute to give effect to the intention of the legislature adding that every section, sub section, paragraph of the Income Tax Act must be given effect to. Also that, section 25(5) of the Income Tax Act, on one hand, and section 18(b) and 39(d) of the Income Tax Act on the other hand, are all part of the same statute, and each intended for distinct purposes and as such, these provisions require harmonious construction to give effect to every word used.

The CAT continued by stating that, section 25(5) of the Income Tax Act relied upon by the Bank was intended by the legislature for purposes of providing guidance in preparation of tax returns before the same are filed for assessment to the TRA. Hence this gives the Bank an opportunity to indicate therein what debt claim has become ripe for deduction with relevant proof to the TRA.

It was added by the CAT that, “We reckon that section 25(4), (5) of the Act, and sections 18 and 39(d) of the Act are not in conflicting positions. They are harmonious in so far as they provide for distinct matters. While sections 25(4), (5) provide for the preparation of accounts, returns and proposal for deductions, sections 18 and 39(d) of the Act gives the TRA the leverage to receive returns and accounts from taxpayers and enjoys finality in the assessment, allowing or disallowing deductions.” (Emphasis is ours)

In dismissing the Appeal, the CAT held that “Much as the Appellant has sought refuge under section 25(5)(a) of the Act, we must point out here that the Appellant did not discharge its evidential burden to prove that it complied with any of the two options the Appellant claimed to have complied with under section 25(5)(a) of the Act. The Appellant has not shown which option it had complied with. There is no evidence to show whether the Appellant exercised the option of disclaiming any entitlement to receive the amount (which it described as charge off).” And concluded that, “there is similarly no evidence to justify the Appellant’s claim that the BOT had approved any loan loss of the Appellant to be written off.” (Emphasis is ours)

5.0 Analysis of the Decision

We Breakthrough Attorneys are of the view that the CAT has not prohibited Banks and financial institutions to claim deductions on the basis of bad debts. Banks may claim deductions when they have satisfied the requisite conditions provided for under the law.  Otherwise they will be treated differently and the tax authority (TRA) wouldn’t allow the deductions.

We are also of the view that, section 18(b) of the Income Tax Act was wrongly relied upon as it does not extend any relief to the Bank as a lender but rather it is an avenue for any borrower with a debt obligation to offset such debts from taxable income if it is shown that the same was used wholly and exclusively into production of business income. It is more like capital which is not taxed. In essence this section, in our opinion, deals with tax in the hands of the borrower and not tax in the hands of the Lender, such as the Appellant in the case. In which case, our analysis, to reiterate, is that the same does not deal with “bad debts” unrecoverable by the Bank and hence could not support the gist of the appeal in favour of the bank.

We are also of the view that, Banks and financial institutions should now go a further step and keep solid evidence proving that the NPLs or other debts have turned into bad debts. Deductions will definitely be allowed by the tax authority (TRA) once there is sufficient evidence.

It goes without saying that, it takes a long time until a Bank or a financial institution can finally be allowed to deduct bad debts. The Bank or financial institution need to first exhaust all recovery measures. These recovery measures are tricky and they take a very long time. Example; for the case of NPLs to be regarded as a bad debt, that particular NPL should within a year of income pass several stages. These are as follows:

• The Bank or financial institution issues to a defaulter a notice – giving the defaulter statutory time limit (60 days) within which he/she should repay the loan,
• With that notice and upon defaulter failure to repay the loan, the Bank/financial institution will have a right to sell the security, or appoint a receiver, or lease a property, or enter possession or sue the defaulter for recovery of the loan,
• To the contrary, the defaulter instead of repaying the loan – could sue the Bank or financial institutions, which is often the case, against the sale of a loan security. These cases usually take time and they go along with injunction orders granted by Courts,
• Otherwise, even before lapse of 60 days, the defaulter may reach the Bank/financial institution and request for another repayment schedule. If the Bank/financial institution accept the defaulter request, another repayment schedule will be entered. Then the procedure in (ii) above will halt for a while,
• The defaulter might later-on breach the later arrangement in (iii) above, with that – the Bank/financial institution may proceed with the procedure in (ii) above,
• The procedure in (ii) above takes a very long time. The Bank/financial institution might even fail to recover the loan amount if due process wasn’t not followed while granting the defaulter the loan. That means, the Bank need to be careful from the time of issuing loan to the time of recovery of the same.

Banks and financial institutions need to comply to the Banking regulations while all the above procedures or other recovery procedures are being employed.

We are also of the view that, in order for the Bank or financial institution to be allowed to deduct bad debts, compliance of Section 25 (4) and (5) of the Income Tax Act is crucial. Even through Sections 18 (b) and 39 (d) of the Act do not apply in the controversy case explained above, Banks and financial institutions need to take note of them while categorizing their bad debts.

In a nutshell, deductions with respect to bad debts or part thereof is permissible subject to the following conditions:

• In the case of a debt claim of by any Bank or financial institution, only after the claim has become bad debt as determined in accordance with the relevant standards established by the Bank of Tanzania (BOT).
• In any other case, only after the Bank/financial institution has taken all reasonable steps in pursuing payment and the Bank/Financial Institution reasonably believes that the debt claim will not be satisfied.
• The debt amount by the Bank/financial institution must have been included in calculating the Bank’s/financial institution’s income for the year of income.
• The debt must have been written off as irrecoverable in the books of accounts of the Bank/financial institution for that year of income in which the debt is claimed to have become bad.

6.0 Conclusion

Breakthrough Attorneys will continue to keep the taxpayers, the general public and other interested stakeholders updated on the interpretation and applicability of the provisions of tax law in order to propagate due compliance with tax legislation.

 

Important Notice:

This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, Breakthrough Attorneys, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.