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Tax Shield

Definition - What does Tax Shield mean?

A tax shield can be described as a reduction in taxes that results from availing an allowable deduction from taxable income. Tax shields vary from country to country and their benefits depend on the taxpayer’s overall tax rate. Some of the common deductible expenses are interest, mortgage, amortization and depreciation. The income may be lowered for a given year, or taxes may be deferred into future years.

Divestopedia explains Tax Shield

A reduction in taxable income achieved by claiming allowable deductions is a tax shield. The investment strategies are often affected by tax shields. A tax shield is a way to save cash flows and increases the value of a firm. Tax shields take different forms, but most involve some type of expenditure that is deductible from taxable income.

The impact of tax shield can be calculated as the amount of expense multiplied by the firm’s tax rate:

Value of interest tax shield= (interest payable) x (tax rate)

Similarly, the value of depreciation tax shield, where depreciation is deducted from taxable income = (amount of depreciation) x (tax rate).

For example, if annual depreciation is $1,000 and the tax rate is 10%, then the depreciation tax shield would be $100. If an accelerated depreciation method is used, which allows for higher depreciation during the early life of an asset, then tax savings are greater during the early stages of the asset’s life.

Different tax shields are available to different entities. Governments often create tax shields to encourage specific behavior or investment in certain industries or programs. An interest tax shield encourages a firm to finance a project through debt. If a firm’s cash flows rely heavily on tax shields it cannot maintain, it may indicate an impending crisis. Similarly, strong cash flows that benefit from ongoing tax shield make the firm appear stronger.

In the instance of a business acquisition, different deal structures may impact the amount of available tax shield. For example, if the stock of a company is acquired rather than the assets, the acquired company will continue to have the same tax base with regards to items such as the tax value of capital assets. If the fair market value of these capital assets is significantly higher than the tax value, the acquirer will forgo the potential tax saving or tax shield from the 'bump-up' that could be gained through an asset purchase.

In a theoretical or notional business valuation, tax shields will be calculated and considered in the overall valuation of a business. In an actual business transaction, tax shield are considered in choosing the transaction structure but rarely are separately detailed in the determination of enterprise value.

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