Tax Shield

A tax shield is the reduction in the taxable income by way of claiming the deduction allowed for the certain expense such as depreciation on the assets, interest on the debts, etc. and is calculated by multiplying the deductible expense for the current year with the rate of taxation as applicable to the concerned person.

Tax shields are an important aspect of business valuation and vary from country to country. Their benefits depend upon the taxpayer’s overall tax rate and cash flow for the given tax year. In addition, governments often create tax shields to encourage certain behavior or investment in certain industries or programs.

A tax shield is a reduction in taxable income for an individual or corporation achieved through claiming allowable deduction as mortgage interest, medical expenditure, charitable donation, amortization, and depreciation.

• This income reduces the taxpayer's taxable income for a given year or defers income taxes into future periods. It is a way to save cash flows and increase the value of a firm.
• This strategy can increase the value of a business since it reduces the tax liability that would otherwise reduce the value of the entity’s assets.
• They are a path to save cash outflows and appreciate the value of a firm. Tax shield in the way of various forms involved in types of expenditure that is deductible from taxable income.

The mathematical expression that helps calculate the tax shield, which enables individuals and institutions to learn about the amount by which their taxable income gets reduced, has been mentioned below:

When it comes to understanding the tax shield definition, understanding how to calculate it under different scenarios is important.

Let us have a look at some of the aspects to check how to calculate the tax shield on:

Depreciation

A tax shield on depreciation is the proper management of assets for saving the tax. A depreciation tax shield is a tax reduction technique under which depreciation expenses are subtracted from taxable income.

This a tax reduction technique under which depreciation expenses are subtracted from taxable income.is is a noncash item, but we get a deduction from our taxable income. This will become a major source of cash inflow, which we saved by not giving tax on depreciation.

It is just like a provision we create every year regarding its capital expenditure.

Interest

One of the important major objectives of a corporation or firm or organization is to reduce its tax liability for which he has to compute

1. The tax advantage of debt.
2. Computing the interest tax shield;

Valuation of the interest tax shield:

1. Capitalize or Recapitalize the value of the firm.
2. Limits on the tax benefits of the debt;

Interest expenses are, as opposed to dividends and capital gains, tax-deductible. Therefore the tax shield is an important factor. These are the tax benefits derived from the creative structuring of a financial arrangement. The tax shield on interest is positive when earnings before interest and taxes, i.e., EBIT, exceed the interest payment. The value of the interest tax shield is the present value, i.e., PV of all future interest tax shields. Also, the value of a levered firm or organization exceeds the value of an equal unlevered firm or organization by the value of the interest tax shield. A lease option is one of the live examples.

Individuals

One of the best illustrations of this concept for an Individual is to acquire a home with a mortgage or loan. The interest expenses associated with the mortgage or loan are tax-deductible, which then offset against the person's taxable income, resulting in a significant reduction in his or her tax liability. Using a housing loan as a tax shield is a major benefit for middle-class people whose houses are major components of their net worth. It also makes beneficiary to those who are interested in purchasing the house, by providing a specific tax benefit to the borrower.

Let us consider the following instances to understand the calculation of tax shield based on different deductions:

Example 1 –Depreciation

A company is reviewing an investment proposal in a project involving a capital outlay of $90,00,000 in a plant and machinery. The project would have a life of 5 years at the end of which the plant and machinery could fetch a value of $30,00,000.

Further, the project would also need a working capital of $ 12,50,000, which would be built during year 1 and released from the project at the end of year 5. The project is expected to yield the following cash profits:

A 25 % depreciation for plant and machinery is available on accelerated depreciation basis as Income tax exemption. Assume that the corporate tax is paid one year in arrear of the periods to which it relates, and the first year’s depreciation allowance would be claimed against the profits of year 1.

The Management accountant has calculated Net Present Value (NPV) of the project using the company's corporate target of 20 % pre-tax rate of return and has considered the taxation effect on the cash flows. The project's cash flows should incorporate the effects of the tax. The corporate tax is expected to be 35 % during the life of the project, and thus the company's rate of return post-tax is 13 % (20 % * 65 %).

Required:

1. To calculate post-tax cash flow at a post-tax rate.
2. Calculate the project's net present value (NPV), considering the tax shield formula.

Tax on cash profit ($ in '00,000s)

Depreciation Allowances- Tax Rebate ($ in '00,000)

Profit on sale of Plant and machinery (30.000 – 21.357) (8.643) (3.025) 6

Calculation of NPV of the project ($ in '00,000)

• * (3.025) + 2.492 = (0.533)

Example 2 - On Interest

ABC Ltd. is considering a proposal to acquire a machine costing $ 1,10,000 payable $ 10,000 down and balance payable in 10 equal installments at the end of each year inclusive of interest chargeable at 15 %. Another option is to acquire the asset on a lease rental of $ 25,000 per annum payable at the end of each year for 10 years. The following information is also available below. The present value factor of 15 % for 10 years is 5.019.

1. Terminal scrap value of $ 20,000 is realizable if the asset is purchased.
2. The company provides a 10 % depreciation on the straight-line method on the original cost.
3. The income tax rate is 50 %.
4. You are required to compute and analyze cash flow and advise which option is better.

Option 1 - Buy

Working notes:

1. In this option the firm has to pay $ 10,000 down and the balance $ 1,00,000 with interest @ 15 % is payable in 10 equal installments. The annuity amount may be calculated for 10 years at 15 % as i.e.,

Annual repayment = $ 1,00,000/5.019 = $ 19925.

1. Discounting rate: we can use the after-tax cost of debt as a discounting rate for both options. We can also use the borrowing rate as a weighted average cost of capital (WACC) and assume that this proposal is already considered in calculating the weighted average cost of capital (WACC). We, therefore, assume that the firm’s WACC is 15 %( the borrowing rate is given above).

Since we have to use the same rate for leasing and borrowing, there will be no change in the final decision, though answers would be different.

1. Depreciation of 10% i.e. $ 11,000 ($ 1,10,000 * 10 %) has been provided for all the years.
2. The asset is fully depreciated during its life of 10 years. Therefore, the book value would be zero at the end of the 10th year. As the asset is having a salvage value of $ 20,000, this would be capital gain, and presuming it to be taxable at the normal rate of 50 %, the net cash inflow on account of salvage value would be $ 10,000 only, i.e. ($ 20,000 * 50 %). This is further discounted to find out the present value of this inflow.

The cash flow of the interest in the purchase option may be calculated as follows:

( Amount in $ )

The Present value of cash outflows may now be found as follows:

( Amount in $)

Option II – Leasing

Evaluation of Lease option. - In case, the asset is acquired on the lease. An annual lease rent of $ 25,000 payable at the end of the next 10 years. This lease rental is tax-deductible; therefore, the net cash outflow would be only $ 12,500 i.e. ( $ 25,000 * 50 % ). The present value annuity factor for 10 years at a rate of 15 % is already provided above, i.e., 5.019.

So, the present value of annuity will be calculated as $ 12,500 * 5.019 = $ 62738.

By comparing the above two options calculated, we concluded that the present value in the case of buying by taking a tax shield is lower than the lease option.

Therefore, it is advisable to go for the buying option (go for the lower expense)

Example 3 – For Individuals

Suppose a cash outflow, interest or salary expenses, is $ 1,000/- and the income tax rate is 30 percent. So the cash outflow which will consider for discounting would be

$ 700/- i.e. $ 1000* (100-30) %.

• Tax shield on Medical expenditure- The taxpayers who have paid more in medical expenses than covered by the standard deduction can choose to itemize to gain a huge tax shield.
• Tax shield on Charity- Charitable giving can lower taxpayers' obligations. To qualify, the taxpayer must use itemized deductions on his tax return. 

Finally, we conclude on account of the above-stated cases that a tax shield can be utilized as a valuable option for effectively evaluating cash flow, financing, etc., activities.

Tax shield offer a significant set of advantages to taxpayers.

Tax shields lower tax bills, one of the major reasons why taxpayers, whether individuals or corporations, spend a considerable amount of time determining which deduction and credits they qualify for each year.

There are various items/expenses whether it is cash or noncash on which an Individual or Corporation claims the tax shield benefits.

This has been a guide to what is Tax Shield. Here, we explain the concept along with its formula, how to calculate it, examples, and benefits. You may also look into the related articles below for a better understanding.

• Tax Shelters
• CAPEX Formula
• Net Operating Loss