Tax Shield

Allowable deductibles from taxable income

What is a Tax Shield?

When you avail deductions that are allowable from taxable income, there are reductions in your taxes and this is called a tax shield. These shields differ between countries and are based on what deductions are taxable. Shields also depend on the effective tax rate for each individual tax payer. Common expenses that are deductible include amortization, depreciation, mortgage payments and interest expense. There are cases where income can be lowered for a certain year due to previously unclaimed tax losses, and this will also result in deferred taxes.

Tax Shield

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How are tax shields strategically used?

Businesses also experience the benefits of tax shields. In fact, because of the disadvantages of removing a tax shield, companies will take these into account when considering the optimal capital structure. Strategies in investment also apply when different payment methods will result in different tax shields.

 

Tax Shield Formula

To save cash flows and to further increase the value of a business, tax shields are used. But for businesses, tax shields may have different forms as this may involve different types of expenditures that can be deducted from the taxable income.  The effect of a tax shield can be determined using a formula. This is usually the deduction multiplied by the tax rate.

Tax Shield = Deduction x Tax Rate

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Interest Tax Shield Example

A company carries a debt balance of $8,000,000 with a 10% cost of debt, and a 35% tax rate. This companies tax savings is equivalent to the interest payment multiplied by the tax rate. As such, the shield is $8,000,000 x 10% x 35% = $280,000. This is equivalent to the $800,000 interest expense multiplied by 35%.

The intuition here is that the company has an $800,000 reduction in taxable income since the interest expense is deductible. This reduces the tax it needs to pay by $280,000.

 

Depreciation Tax Shield Example

For instance, if the yearly depreciation is at $2,000 and the rate of tax is set at 10%, the tax savings for the period is $200.

For depreciation, an accelerated depreciation method will also allocate more tax shield in earlier periods, and less in later periods. The tax savings are larger because there is a larger deduction. However, it is important to consider the effect of temporary differences between depreciation and capital cost allowance for tax purposes.

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Adding Back a Tax Shield

When adding back a tax shield for certain formulas, such as free cash flow, it may not be as simple as adding back the full value of the tax shield. Instead, you should add back the original expense multiplied by one minus the tax rate. This is because the net effect of losing a tax shield is losing the value of the tax shield, but gaining back the original expense as income.

In our interest expense example, the original value of the shield is $280,000. We know assume, however, that this debt was a convertible bond. To calculate the income effect of this bond’s conversion on diluted EPS, we have to add the after-tax interest expense back to net income. Thus, the value added back is found as follows:

After-Tax Interest Expense = Interest Expense x (1 – Tc)

 

Interest Tax Shield Example Continued

Our convertible bond pays out a coupon of $800,000 this year. The tax savings would have been $280,000 had the bond not been converted. If this bond was converted, however, the net value of the lost tax shield is $800,000 (1 – 35%) = $520,000.

The intuition here is that although we lose the $280,000 in tax shield, we gain the interest expense of $800,000 back (since we are not obliged to pay it out anymore). The net effect is -$280,000 + $800,000 = $520,000.

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