* Tax breaks seen as key for bank consolidation in Italy * Draft bill extends measure by six-months, boosts size * Tax breaks for bad loan sales could also be prolonged (Adds details) ROME, May 3 (Reuters) - Italy is considering extending to mid-2022 tax breaks which are expected to spur tie-ups in its fragmented banking sector, while also boosting the size of the incentives, a draft decree seen by Reuters showed on Monday. The draft bill also reintroduces for the current year tax benefits for companies shedding impaired loans which had expired in December. Both measures, if confirmed, would support Italian banks weather the fallout from the pandemic, which is set to stoke bad debts and further hit bank profits once the government unwinds support measures for the economy. In this respect, the government is considering extending state guarantees on bank loans to firms and a debt holiday scheme, with only interest payments resuming after June. The tax breaks for corporate mergers, due to expire in December, are a key plank of an incentive package Italy’s former government had readied to convince the country’s no.2 bank UniCredit to taken on loss-making Monte dei Paschi (MPS). Negotiations over state-owned MPS have hit a wall due to a change of CEO at UniCredit, where Andrea Orcel last month took over from French banker Jean Pierre Mustier. The proposed changes extend the timeframe for possible mergers and give banks an even bigger incentive to join forces and buttress profits through cost cuts. Bailed-out MPS had said in March the measure currently in place, which allows companies merging to turn past losses into tax credits, entailed a 2.2 billion euro benefit for a buyer. The draft decree proposes raising the cap on the tax breaks to 3% of the assets of the smaller company involved from the current 2% at present. The cost for state coffers would amount to 1.05 billion euros ($1.3 billion) spread over three years, the draft decree said. It would cost the state another billion euros to prolong the tax incentives for bad loan disposals for another year, which the bill said could lead to sales totalling 17 billion euros this year, of which 10 billion from banks. The Bank of Italy says the tax breaks helped banks offload 33 billion euros in problem loans last year. Ministers in Mario Draghi’s government are expected to discuss the decree, which can still be amended, at a cabinet meeting on Friday, a government source said.($1 = 0.8297 euros) (Reporting by Giuseppe Fonte and Valentina Za; Editing by Gavin Jones and Alexander Smith)