A Tax Shield is an allowable deduction from taxable income that results in a reduction of taxes owed. Tax shields differ between countries and are based on what deductions are eligible versus ineligible. The value of these shields depends on the effective tax rate for the corporation or individual (being subject to a higher rate increases the value of the deductions).
Common expenses that are deductible include depreciation, amortization, mortgage payments, and interest expense. There are cases where income can be lowered for a certain year due to previously unclaimed tax losses from prior years.
Corporations and individuals both experience the benefits of tax shields. There are two main strategies companies use:
Capital structure optimization
Accelerated depreciation methods
The impact of adding/removing a tax shield is significant enough that companies will take it into account when considering their optimal capital structure, which is their mix of debt and equity funding. Since the interest expense on debt is tax-deductible (while dividend payments on equity shares are not) it makes debt funding that much cheaper.
Since depreciation expense is tax-deductible, companies generally prefer to maximize depreciation expenses as quickly as they can on their tax filings. Corporations can use a variety of different depreciation methods such as double declining balance and sum-of-years-digits to lower taxes in the early years.
It should be noted that regardless of what depreciation method is used the total expense will be the same over the life of the asset. Thus, the benefit comes from the time value of money and pushing tax expenses out as far as possible. Since depreciation is a non-cash expense and tax is a cash expense there is a real-time value of money saving.
Tax Shield Formula
To increase cash flows and to further increase the value of a business, tax shields are used. The effect of a tax shield can be determined using a formula. This is usually the deduction multiplied by the tax rate.
A company carries a debt balance of $8,000,000 with a 10% cost of debt and a 35% tax rate. This company’s 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 example, if a company has an annual depreciation of $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.
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 annual value of the shield is $280,000. We now 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.