Tax shield

Tax and treasury.

1.

Broadly, the benefit to a taxpayer of the tax deductibility of certain business expenses - including borrowing costs - thus reducing their taxable income and their tax expenses.

The term most often refers to borrowing costs - including debt interest - which are normally tax-deductible.

This gives rise to tax shield benefits and reduces the after-tax cost of debt for corporate borrowers.

In cash terms, the annual tax savings for a tax-paying corporate borrower can be quantified as:

Annual tax-deductible debt servicing costs paid (D x Kd) x relevant rate of corporation tax (t)

Example 1

D = Debt, for example $100m.

Kd = Pre-tax % cost of debt, for example 5%.

t = Relevant corporate tax rate, for example 28%.

So the annual tax shield benefit in $m is:

= 100 x 0.05

= $5m annual interest charge, reducing annual taxable profits by $5m

Related annual tax saving:

= $5m x 28% tax rate

= $1.4m.

Another perspective on quantifying tax shield benefits is the reduction in after-tax cost of debt.

Example 2

= 5% x (1 - 0.28)

= 3.6%.

3.6% in this case compared with the before-tax cost of debt of 5%.

2.

More narrowly, the total present value of all of the expected future related cash flow benefits arising from the use of debt.

The total present value of the expected future cash flow benefits from the tax savings can be quantified/estimated by capitalising the annual saving at the pre-tax cost of debt.

A simple estimate values the cash flow benefits as a fixed perpetuity, using the perpetuity factor 1 / Kd.

Example 3

Annual saving = $1.4m

Kd = 5%

Total present value of tax shield:

= 1.4 x (1 / 0.05)

= $28m.

It can also be quantified more simply as D x t.

Example 4

= 100 x 0.28

= $28m as before.

See also

• Adjusted present value
• Corporation Tax
• Cost of debt
• Cost of capital
• Gearing
• Ordinary shares
• Perpetuity
• Preference shares