A Tax Shield is the use of taxable expense that helps a business to lower its tax liability. Or, we can say it is the reduction in the assessable income because of the use of allowable deductions. The primary objective of a tax shield is to lower the tax liability or shield income from the tax. These are critical when the income of a business is too high. The use of this shield or taxable expenses helps bring the taxable income down.
Necessary tax shields are making charitable contributions, loans or debt, medical expenses, acquiring fixed assets, etc. A point to note is that mortgage or debt itself is not a taxable expense. Instead, the interest on a loan is a taxable expense. Similarly, buying assets is not a deductible expense; instead, the depreciation and repairs thereon on that asset help to lower the taxable income.
Types of Tax Shield
As said above, there could be several types of tax shields – interest expenses, charitable contributions, medical expenses, and depreciation. Lets’ discuss them in detail:
Interest that a company pays on a loan or debt it carries on its balance sheet is tax-deductible. We also call this Interest tax shield. The tax savings for the company is the amount of interest multiplied by the tax rate. For example, Company ABC has a 10% loan of $200,000, and the applicable tax rate is 20%. The tax shield in this case will be $4,000 (10% * $200,000 * 20%).
If the medical expenses you pay are more than the standard deduction, then the excess amount is tax-deductible.
Donation to approved organizations also qualifies as tax-deductible. However, the taxpayer needs to itemize the deduction to take a tax deduction.
Depreciation that a company charges on assets are also tax-deductible. The deduction applies to both tangible (equipment, furniture and fixtures, and vehicles) and non-tangible assets (software, patents, etc.). However, to get the deduction, the asset must be used in a business or helps the business to generate income. Another requirement is that the asset must have an expected lifespan of over a year.
In the case of depreciation, the quantum of the amount eligible for a tax shield may vary based on the depreciation method in use. For instance, accelerated depreciation will result in more tax savings in the initial years.
Importance of Tax Shield
The following points can help in understanding the importance:
- Businesses, both big and small, can immensely benefit from the use of a tax shield. It helps boost the value of an organization as it lowers the tax liability, which otherwise reduces the amount of assets.
- Further, it helps to boost the cash flow. It is because it lowers the tax, meaning thereby lower cash outflow.
- The importance of this is also evident from the fact that companies consider it when deciding on optimal capital structure. For those unaware, capital structure is the mix of debt and equity funds that a company uses for its operations. The fact that interest on the debt is tax-deductible makes a mortgage a cheaper financing option.
- Additionally, tax shields also play an essential role in deciding the depreciation method a company follows. To maximize depreciation expenses or lower tax liability in the initial years, a company may go for a double-declining balance and sum-of-years-digits approach. A point to note is that a depreciation method has no impact on the total amount of depreciation over the useful life of an asset. The benefit is primarily in the form of the time value of money and also because it pushes the tax expenses to later years. Another advantage is that because depreciation is a non-cash expense, tax results in a real cash outflow. So, high depreciation leads to cash savings.
- Another strategic importance of tax shields is that they influence crucial business decisions. For instance, suppose a business is evaluating whether to buy or lease a building. For a better choice, a company should consider the tax benefits it would get by taking a mortgage to purchase the building.
How to Calculate Tax Shield?
The amount of benefit from tax shields may vary from country to country. Another factor that determines the benefits is the taxpayer’s applicable tax rate. For instance, the higher the tax rate, the higher will be the tax shields.
We can easily calculate the value of a tax shield. We need the sum of taxable expenses and the tax rate for this. For instance, if a company pays $2,000 as interest on a loan annually, and the tax rate is 20%, then the tax shield value is $400 ($2,000 * 20%). It means that the $2,000 interest expense helped the company to save $400 in taxes.
Refer to Tax Shield Calculator
Adding Back Tax Shield
There are specific scenarios when we need to add back the tax shield, such as when calculating free cash flow (FCF). However, adding back the protection is not straightforward because we need to consider the net effect of losing a tax shield. And this net effect is the loss of the tax shield value but again of the original expense as income.
Lets’ understand this with the help of an example of a convertible bond. In such a case, one needs to add back the after-tax interest expense to the income. A formula to calculate after-tax interest expense is – interest expense * (1 – Tax Rate). This after-tax interest will be the amount that needs to add back.
In the above example, the convertible bond pays a coupon of $2,000 annually. If we do not convert the bond, the tax savings would be $400. But, if we avail the option to convert the bond, the net value of lost tax shield is $2,000 * (1 – 20%) = $1,600. It is because $400 has already been saved, or there is $400 less cash flow due to the tax shield. So, adding back $1,600 will add back interest equivalent to $2,000.
Tax Shield For Individuals
It is not just for the companies but for the individuals as well. Similar to companies, individuals can also get tax benefits by making donations, medical expenses, depreciation, interest expenses, and more.
One classic example of this is a home loan. The interest that the borrower pays on loan is tax-deductible. It reduces the borrowers’ taxable income and, in turn, their tax liability. Interest in student loans also works as a tax shield. The interest that one pays on the student loan is tax-deductible.
You now know that maximizing tax-saving benefits using tax shields must play an essential role in every financial decision. However, you should not solely depend on tax shields when making a decision but must keep in mind that ignoring it may lower the value of the business.