Updated July 11, 2023
Definition of Tax Shield
Tax Shield (T.S) is a tax reduction that individuals and businesses avail by opting for certain deductions that result in a reduction in taxable income leading to an overall reduction in tax liability.
It is availed by certain eligible tax deductions, which can be due to interest payment on debt component, non-cash expenses like depreciation and amortization, and tax allowances applicable to individuals such as Medical Premium, Donations to eligible for tax deductions, etc. T.S. rates and a list of items on which T.S. applies vary from country to country depending upon Income Tax Rules prevalent in the country. Also, Tax Shield eligibility is dependent on the tax slab to which the individual or business belongs.
Explanation
T.S. implies a reduction in tax liability because of investment in tax-deductible instruments and interest tax shields from the business’s interest expenses. Tax shield enables enterprises to use leverage in their capital structure as interest paid on debt borrowing is tax-deductible. Tax shield works as part of individual tax planning and for business as part of corporate business strategy.
T.S. is an indispensable part of business planning. A successful business always optimizes T.S. by improving profitability, reducing tax outgo, enabling a more optimized capital structure, etc.
The Formula for Tax Shield
The formula is straightforward and expressed as follows:
Let’s take a simple example to apply the above formula:
Suppose the Taxable Income is $1000 and deductible expense amount to $300 with a tax rate of 15%. In such a case, the tax shield compute as follows:
- Tax Shield = $300*15%
- Tax Shield = $45
Thus Taxable Income declined from $1000 to $955 because of the T.S.
Examples
Following are the example of tax shied.
Example #1
ABC Limited has provided the following information. Based on the same, compute the tax benefit accruing to the company.
Depreciation Expenses $10000
Interest Expenses $40000
Donations to charitable trusts of $5000
Applicable Tax Rate 35%
The company has reported an Operating Income of $80000.
Solution:
Tax Shield calculates as
Tax Shield = (Donation to Charitable Trusts + Interest Expenses + Depreciation Expenses) * Applicable Tax Rate
- Tax Shield = ($5000 + $40000 + $10000) * 35%
- Tax Shield = 19250
Tax Shield 19250
Taxable Income $80,000
Revised Taxable Income calculates as
Revised Taxable Income = Taxable Income / Tax Shield
- Revised Taxable Income = $80,000 / 19250
- Revised Taxable Income = $60,750
Example #2 – Tax Shield on Interest
Interest on debt undertaken by the business is tax-deductible across various jurisdictions. Under this, an organization can reduce its tax liability on account of interest paid on Debt borrowing.
Let’s understand with the help of an example:
ABC Company has provided the following details related to its borrowing and associated costs:
Net Debt Balance $1000000
Average Cost of Debt 12%
Applicable Tax Rate 30%
Debt Eligibility for Tax Shield Yes
Based on the above, we can compute the net interest outgo for ABC Company and T.S:
Solution:
Interest Outgo = Net Debt Balance * Average Cost of Debt
- Interest Outgo = $1000000 * 12%
- Interest Outgo = $1,20,000
Tax deduction on Interest Outgo = Interest Outgo * Applicable Tax Rate
- Tax deduction on Interest Outgo = $1,20,000 * 30%
- Tax deduction on Interest Outgo = $36000
Thus on an Interest outgo of $120000, ABC Company will get a T.S. of $36000, resulting in a reduction of its tax liability by that amount outright.
How Does Tax Shield Save on Taxes?
T.S. saves on taxes by reducing the tax liability a business or individual must pay. The business is liable to pay by keeping on taxes, which increases cash flows. The intention behind using a T.S. is deferred or avoidance of tax liability.
Businesses and Individuals, by claiming exemptions that are liable for tax deductions, save on their tax outgo.
There are multiple strategies for businesses and individual users to save on taxes. A few noteworthy are enumerated below:
- Borrowing through the issuance of debt instruments by business saves on taxes.
- Donation to an eligible charitable organization enables businesses to comply with corporate social responsibility and reduce tax liability.
- Interest on Mortgage payments made by individuals is tax-deductible.
- Investment in Tax saving instruments up to a certain threshold limit by individuals results in a reduction in tax liability.
An important point to understand for businesses while obtaining debt to benefit from the T.S is that the optimal proportion of debt as part of capital structure is reached when the marginal benefit provided by the T.S of taking on additional debt is equal to the marginal cost of financial distress incurred from the other debt.
Uses of Tax Shield
T.S. serves multiple purposes; however, its main usage revolves around reducing tax liability and effectively the Net tax outflow. In addition, at times, the T.S. helps make decisions about leasing and buying. Also its usage is found in multiple capital budgeting decisions as well.
The tax shield helps businesses opt for the accelerated depreciation method as it leads to more T.S. allocation in the initial years of business, making it more NPV positive.
Benefits
The T.S. offers multiple benefits. A few noteworthy ones are enumerated below:
- This reduces the tax liability but doesn’t always result in more cash inflow for the business.
- It improves business valuation by resulting in more Free Cash flow to the firm, an important yardstick for business valuation.
- It enables business decisions to be undertaken after taking into consideration tax benefits. At times, certain projects become NPV-positive because of the T.S. they offer.
- It helps minimize the business’s Weighted Average Cost of Capital (WACC) and maximize business valuation.
Conclusion
Tax Shield provides important tax breaks which help individuals and businesses to reduce their taxable income leading to lower tax liability. Every country’s tax system provides a list of instruments, income slabs, and threshold limits of tax exemption items that the business and individuals to obtain a T.S. Also, a Tax shield is an important component in investment decisions for businesses and Investors. Business usually prefers investing in projects where they can avail T.S. Similarly, individuals prefer investing in financial instruments tax exempted to reduce their cash tax outflow.
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