Concerned over rising non-performing assets in the banking sector, the budget for 2010-11 may reduce the tax on funds banks set aside to cover potential losses from loans that aren't likely to be repaid.

At present, only 7.5% of the amount banks set aside for covering bad and doubtful debts is allowed as deduction from income while calculating the tax liability.

"The deduction amount could be increased to 50%, though banks have demanded a full waiver," a senior finance ministry official told ET.

The ratio of gross non-performing assets, or NPAs, to gross advances for commercial banks rose to 2.39% in 2009-10 from 2.25 % in 2008-09 and is likely to climb further in the current fiscal.

In absolute terms, the total NPAs of scheduled commercial banks stood at 74,685 crore at the end of March 2010.

Banks are worried that if the concession is not provided then their profits could take a hit as the banking regulator, the Reserve Bank of India, has increased the provisioning requirement.

The guidelines require banks to achieve a provision coverage ratio of 70% by September 30, 2010, seeking to build a cushion in good times to absorb higher losses when things turn bad. That is, provisions made against NPAs should be at least 70% of the gross amount of such advances. For instance, if a bank has 100 worth of NPAs, it would have to provide at least 70 against such profits.

The higher provisioning will clearly reduce bank profits if the deduction stays at 7.5%. A higher deduction, on the other hand, will reduce the tax liability, encouraging banks to go beyond the stipulated 70% minimum provisioning when profits are good.

Under the earlier rules, the provisioning requirements for NPAs ranged between 10% and 100% of the outstanding amount, depending on the age of the NPAs and the collateral available.

The banks have argued that while they are being asked to allocate more amount towards provisioning, the tax rebate offered is dismal.

"The rebate will help to retain profits and thus increase lending, which is what the government wants," a State Bank of India official said.

SBI, the country's largest lender, had a provision coverage ratio of 64% at the end of December 2010. Analyst peg the incremental provisioning required for reaching the 70% target is about 2,000 crore.

In their pre budget consultations with finance minister Pranab Mukherjee , banks had also demanded that their non-interest income should not be subjected to tax deduction at source, or TDS.