July 02, 2021

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What is Tax Shield?

What is Tax Shield?

Overview

Tax payments is a topic that you get familiar with as soon as you get your first job or start your own business. Many find the tax payments to be a big burden for them financially in addition to simply being complicated due to various tax laws and regulations. Although there is no really a way around this, there are numerous ways to make this burden at least somewhat lighter.

Most people are familiar with the term tax deductions. These deductions make total income lower than it actually is, which cuts down the tax bill as well. In fact, there are many eligible tax deductions that one can use for tax savings. Unfortunately, not everyone understands the meaning of a tax shield and how they can strategically use it to lower the amount they have to pay the government.

The ultimate goal of any business owner is to see the value of their business grow and, accordingly, to increase the wealth of the owners. In order for a business to grow and develop, own funds are often insufficient and the question of attracting borrowed capital arises. But even if the equity capital (i.e. the owners’ capital) is sufficient to cover all the business needs for working capital and long-term financing of investment projects, raising debt financing may still be a good idea.

What is Tax Shield?

It should be noted that certain types of payments, for example, regular payments on borrowed loans, in accordance with the legislation, may not be subject to taxation. This is called a tax shield, which is an allowable deduction from taxable income that saves you money on the tax bill.

A tax shield is a certain effect that occurs when restructuring financial capital. There is a decrease in the volume of corporate tax due to an increase in the part of the borrowed capital. Loan interest is paid before income tax is charged. Depreciation does not really cause cash flow. However, depreciation also provides a so-called “tax shield”.

In other words, a tax shield is a decrease in a company’s tax liabilities amount caused by an increase in costs that can be subtracted from the income based on which the taxes are calculated. Business valuation is closely tied with the concept of tax shield because it allows to save money and increase cash flows. The tax shield computation is represented by the formula above.

Interest Tax Shield

Now, let’s look at the impact that having debt has on the organization’s Income statement, which is going to take the form of the interest tax shield. This is very valuable to companies. For instance, we are looking at Bear company that has a 35% tax rate. In the year 2020, the company had interest equal to $25,000 and in 2021 the interest is $28,000. What is the interest tax shield this company is going to get by using debt?

The good news is that there is not a lot of calculations to do. You would simply multiply the $25,000 by 35% to get $8,750 for the year 2020 and the $28,000 by 35% to get $9,800 for the year 2021. This means that the Bear will have a taxable income reduced by $8,750 and $9,800 thanks to the tax shield. Basically, by having a larger debt, the company is actually saving a significant amount in tax payments.

Depreciation Tax Shield

Let’s continue to use Bear company as our example. In the year 2020, this company had a revenue equal to $980,000 and a depreciation expense of $10,000. What would be the benefit of using a tax shield?

By subtracting the depreciation tax shield amount from the revenue, you will get an EBIT value of $970,000. The tax payment will be $970,000 x 35% or $339,500. After subtracting the tax expense, you arrive at the net operating profit after tax of $630,500. Now, to get the cash profit amount, you would need to add back the depreciation expense because it is a non-cash charge. This would give us a cash profit value of $640,500.

Now, let’s assume the company did not account for the depreciation. The tax payment in this case will be equal to $343,000. After subtracting the tax expense, you arrive at the net operating profit after tax of $637,000. At this point, it looks like the company is better of when depreciation is not added into the calculation. However, remember that when it comes to the actual cash profit value, the $637,000 (no depreciation to add back) is lower in comparison to the previous case where you had a cash profit of $640,500.

As you can see, the Bear company would be $3,500 short in the second case when it forgot to deduct the depreciation. To arrive at this number, you can simply use the tax shield formula, where you would multiply the depreciation amount of $10,000 by the tax rate of 35%, which would give you $3,500. Thus, a tax shield is an amount by which the depreciation and amortization (or any non-cash charge) lower your income subject to taxation, creating cash savings.

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Author: Charles Lutwidge

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