Tax Shield Approach- Depreciation and Interest Tax Shields

Definition of tax shield

Tax shield approach refers to the process of the amount of reduction in taxable income for a corporation or individual achieved by claiming allowable deductions like medical expenses, amortization, loan or debt, mortgage interest, depreciation and charitable donations.

These deductions help the taxpayer to reduce their taxable income in the current year or defer income taxes into upcoming years. The tax shield approach lowers the amount of tax owed by a business or an individual. 

• Therefore, the tax shield approach refers to the deliberate use of taxable expenses to offset the company’s taxable income. 
• The strategy can increase the value of a business, as it reduces the tax liability that would have in turn decreased the value of the entity’s assets. 
• The effects of the tax shield approach must be used in cash flow analyses since the amount of cash paid is impacted. 
• The concept is critical, helpful and beneficial where the income of a business, individual or corporation is of high net worth. 

For example, To use the tax shield approach, an individual acquires a house with a mortgage. However, the interest expense linked with a mortgage is tax-deductible, which offsets against the individual’s taxable income. Therefore it reduces his tax liability significantly.

Types of Tax Shield Approach

This must be noted that the term debt or mortgage is not the taxable expense, rather the interest on these loans is a taxable expense. Likewise, buying assets or fixed assets is not a deductible expense, but repairs and depreciation on those assets help lower taxable income. Few types of tax shield approach are discussed below:

Medical Expenses 

If an individual or a business has medical expenses more than the standard deduction, can choose to itemize and then the excess or rest over amount is tax-deductible.

For example, for the year 2019 or 2020, a person can deduct the amount linked with dental or medical expenses that exceed 7.5% of adjusted gross income( by filing schedule A).

Interest Expenses 

Interest that a person pays on debt or a loan carried on the financial statement or balance sheet is tax-deductible. This turns out to be of major benefit to middle-class people. Student loan interest also has similar functions. This is also termed as an interest tax shield approach which will be studied in brief later. The tax savings are calculated as the amount of interest multiplied by the tax rate. 

For example, For a company with a 15% loan of $200000 and a tax rate as 25%, the tax shield approach will be 15% x $200000 x 25% = $7500.

Depreciation 

Depreciation or amortization charged on tangible and intangible assets are also tax-deductible. These deductions include tangible( furniture, equipment, vehicles etc) and intangible (patents, goodwill, software etc). The assets must be used to attain income in a business to receive the facility of deduction. However, there are other terms and conditions associated which will be discussed in depth.

Charitable Contributions

A donation made to approved organizations also comes under the category of reducing tax. However, the percentage depends upon the kind of charity and also a taxpayer must itemize the deduction on his tax return. The deductible amount can be 60% of the person’s adjusted gross income depending on certain situations. Therefore to qualify they must be through an approved one.

Importance of Tax Shield Approach

Acting as a shield towards the tax liability of the company counts as the major advantage of the tax shield approach. Therefore, there are a few key points that help to know the importance of the tax shield approach:

• The tax shield approach indirectly helps to boost the cash flow. This happens when the process lowers the tax resulting in less cash outflow. 
• Any size or nature of business whether small, medium or big can benefit from the approach. It boosts the value of the organisation by reducing taxpayer obligations.
• Similarly, it plays an essential role in deciding the type of depreciation method that a company follows. High depreciation leads to cash savings. However, this must be noted that the type of method only matters with the time value of money and no impact on the total amount over the useful life. 
• Companies also consider it while deciding an optimal capital structure. Referring to a mix of debt and equity funds used for the operations by the company is capital structure. Therefore, since interest on debt is tax-deductible, it makes mortgage a cheaper finance option.
• Lastly, they influence a company’s crucial decisions. For example, if a business is analysing whether to lease or purchase a building. Therefore, for such choices, the business has to keep in mind the tax benefits it would gain by taking a mortgage for the same which is a part of the tax shield approach.

Tax Shield Formula

The tax shield approach varies from country to country. Therefore, based on it the deductions are explained whether legitimate or not. The value for the tax shield approach also depends on the corporation or individual effective tax rate. Also, there can be cases when the current year’s income can be reduced than the previous year due to unclaimed tax losses of the preceding year. 

As a result, the company uses two strategies to calculate the tax shield formula:

• Accelerated depreciation
• Capital structure

Accelerated Depreciation

Companies try to maximise their expense for depreciation to incorporate the tax filings. Moreover, they use different depreciation methods like the sum of years digits and double-declining balance method (to utilize the time value of money) to lower taxes for recent years. 

Capital Structure

The influence of removing or adding a tax shield approach is impacted by the optimal capital structure ( mix of equity and debt funding) that the company chooses. Also, the interest expense is tax-deductible on the debt which makes the selection of debt funding cheaper. However, the company cannot raise the maximum funds from debt since it increases the financial risk.

Tax Shield formula 

Tax Shield = Amount of tax-deductible expense x Tax rate 

For example, if an individual has $2000 as mortgage interest with a tax rate of 10%, then the tax shield approach will be worth $ 200.

Uses / Relevance

The Tax Shield approach minimizes the tax bills for the taxpayer. As a result, the person spends time determining the tax or credit every year using the tax shield formula. Therefore, certain uses of the tax shield formula are as follows:

• The tax shield formula allows calculating the type and amount of expenditure to be deducted directly from the taxable income. It helps to save cashflows.
• It decreases the taxable amount for the current year or imposes deferring income tax into future years. Therefore, it increases the value of an organisation.
• A tax shield formula determines the future tax saving attribute of tax by showcasing an organisation’s present value. Along with which it predicts the particular expenditure deductibility in the P & L account.

Depreciation Tax Shield 

Depreciation refers to the reduction in the value of tangible assets over some time due to wear and tear. However, depreciation can be used as a tax shield approach by decreasing the depreciation expense from taxable obligation. Therefore, the depreciation tax shield formula can be calculated by multiplying the corresponding expense with the tax rate. 

• Various methods can be used by a company to calculate depreciation according to their convenience. Whereas, Companies that use accelerated depreciation methods that are higher in recent years, save more due to the higher value of the tax shield approach. Whereas in the case of the straight-line method, the amount of reduction is lower. 
• Although the overall amount of depreciation remains the same using the entire life usage of the asset.
• It just depicts the utilization and benefit of the time value of the money to push tx expenses out as far as possible.
• Tax is a cash expense and depreciation is a non-cash expense, therefore it is a real-time value of money-saving.
• Also, there is a condition that the asset must be used to generate income in the business. Another can be that the assets should have an expected life of around a year.

Depreciation tax shield formula 

Depreciation tax shield = Depreciation expense x tax rate

For example, 

Below we have two segments:  ( Tax rate = 40%)

• The first two columns of Taxable income with Depreciation
• The following two columns of taxable income without depreciation

Therefore, 

Amount of Tax Paid  = ( Revenue – Operating expenses – Depreciation – Interest ) x Tax rate          OR                                = EBT x Tax rate

 So, it must be noted that depreciation directly impacts the profits/margin of safety percentage since the net income comes down if depreciation expense is rising which decreases the tax liability or obligation. Whereas if a company do not take depreciation into account, then the taxable income is higher.

Importance of Depreciation Tax Shield Formula

• To promote the activity of investment for different socio-economic development, the government provides the company with a higher depreciation rate (40-100%) which is tax-deductible.
• To combat climate change and boost renewable energy generation from the company, the govt allows incentives by lowering their tax expenses. This is done by allowing investor’s accelerated depreciation benefits so that it invests money in solar power projects or wind power.

Interest Tax Shield

As the name suggests and discussed earlier, the interest tax shield approach refers to the deduction claimed in the tax burden due to the interest expenses. This explains that if an individual or corporation has a loan or mortgages and are paying interest on the same.

They can use this to the advantage of the company since interest is a tax-deductible expense. There it becomes another important and common tax shield approach for the firms.

Risk Associated 

Despite the benefit that the debt provides, not various companies prefer them. One major reason can be counted as the fear to meet interest payments. Another barrier can be “covenants” that flow along with the debt.

Covenants are termed as points or restrictions that an organisation has to agree to for obtaining the loan or debt. To start, an organisation may have to agree to refrain from an action like not selling back their assets. Moreover, a few covenants demand the company to maintain various ratios such as debt coverage ratio or debt-equity ratio.

In conclusion, these covenants are present to ensure that a company dares to meet its financial obligations in time. However, if the company is not able to meet these points, the debt makes it even more expensive for them to suffer leading to financial pressure.

As a result, to recover, the management may refrain from productive investments or even take their money out from operations to serve the debt amount. This can lower the value of the company concerning future cash generations.

Valuation of Interest Tax Shield

The main idea here only lies to reduce the investor’s tax burden as far as possible. However, the interest tax shield approach encourages the companies to finance the projects with debt since the dividends paid via equity investors are not tax-deductible. 

The interest tax shield is positive when the EBIT is greater than the payment of interest. Moreover, this must be noted that interest tax shield value is the present value of all the interest tax shield.

An interest tax shield approach is useful for individuals who want to purchase a house with a mortgage or loan. The person gets the benefits while he offsets his taxable income. Also, like depreciation, the interest tax shield approach differs from country to country.

For example, XYZ company has a debt of $80,00,000 with a 10% interest and a 40% tax rate. Therefore the shield will be $80,00,000 x 10% x 40% = $ 320,000.  Here, the company has $800000 as interest expense which explains that the tax reduced by $320,000.