* 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 detail and updates prices) ROME, May 4 (Reuters) - Italy is considering extending to mid-2022 tax breaks that are expected to spur on mergers in the fragmented banking sector, while boosting incentives for any tie-ups, a draft decree showed. The draft bill, first reported by Reuters on Monday, also reintroduces for the current year tax benefits for companies shedding impaired loans which had expired in December. Both measures, if confirmed, would help 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 prepared to convince the country’s No.2 bank UniCredit to take 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 by six months and give banks an even bigger incentive to join forces and buttress profits through cost cuts. 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. 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 ($2.6 billion) benefit for a buyer. Equita analyst Andrea Lisi estimated the new scheme would mean a 3.4 billion euro boost for UniCredit if it took over MPS. Lisi said the reward would rise to 3.6 billion euros in a tie-up between UniCredit and Banco BPM, Italy’s third-largest bank widely seen as an alternative potential takeover target for UniCredit. Shares in MPS gained 2.6% on Tuesday, against a 1.3% drop in Italy’s banking sector. The cost for state coffers would amount to 1.05 billion euros spread over three years, the draft decree said. It would cost the state another 1 billion euros over the same period 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, with 10 billion euros 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. MP Giovanni Curro told Reuters his co-ruling 5-Star party would ask parliament to change the measures, if they are approved, to curb the incentives. $1 = 0.8333 euros Reporting by Giuseppe Fonte in Rome and Valentina Za in Milan; Editing by Gavin Jones, Alexander Smith and Edmund Blair Our Standards: The Thomson Reuters Trust Principles.