Taxes are necessary, and few would tell you different. From running water to corporate subsidies to encourage growth, the services provided by governments are paid for by taxes collected from individuals and corporate entities. However, there are certain ways that corporate finance allows for protection against paying too much in taxes. These are called tax shields, and there are many different types that a good CFO will have as tools at their disposal, including an interest tax shield.
So what is the interest tax shield and how does it work?
To understand this, you first need to have a reasonable understanding of corporate taxes. So start with that.
Corporate Taxes – A Brief Overview
There are all kinds of taxes you people pay as individuals. And corporate entities have even more income streams and many more headwinds when it comes time to prepare their tax statements.
The job of a good CFO is to improve the company’s financials by optimising the taxable income so the company isn’t paying more tax than it needs to.
This can sound somewhat contentious, but it’s important to note that this is not an article about tax avoidance or tax evasion.
Rather, it’s about one particular tool – the interest tax shield – and how it’s used to optimise a company’s tax liability.
If a company paid full tax on all of its revenues without any deductions, the amount of money required to remain profitable would be almost impossible to maintain from a business perspective.
That’s why the government embedded several tax shields in the tax laws to allow a company to deduct things like:
- costs of goods sold,
- general and administrative expenses,
- research and development,
- depreciation, and
- some operating costs.
As a result of deducting these expenses, a company’s “taxable income” decreases.
This in turn reduces the tax liability of the company.
What Does It Mean for Corporate Finance?
When tax shielding opportunities are highlighted and tracked effectively, companies can reduce the amount of corporation tax they pay.
This improves several financial ratios that investors use to value the company, such as those that compare the revenues to profits.
If the company keeps more of the profit it earns, that allows more resources for growth.
Generally speaking, the higher the retention ratio of a firm, the higher its growth rate.
In case you’re not familiar with the “retention ratio”, it’s just the ratio of profit retained in the business, calculated as:
Retention Ratio = Profit Retained for the Year / Net Profit for the Year
Okay, now that you have a reasonable understanding of corporate tax and tax deductible expenses, let’s dive into the interest tax shield.
What Is the Interest Tax Shield?
An interest tax shield refers to the tax savings made by a company as a direct result of its debt interest payments.
As is hopefully clear by this stage, the interest tax shield is just one example of the tax shielding opportunities available to companies.
Obviously, a company makes money from interest income related to investments. But that interest counts as income on a company’s books so would not lead to tax deductions.
The interest tax shield relates to interest payments exclusively, rather than interest income.
Interest payments are deductible expenses for most companies.
The deductible interest paid on debt obligations reduces a company’s taxable income.
This in turn reduces the total amount of tax payable by the firm.
How Does an Interest Tax Shield Work?
Interest gets paid out from a company on business loans it takes out. The same applies for any other form of debt the firm raises.
Company debt is usually a much larger amount of money than individuals have to worry about.
And debt can often be a necessary part of a company’s ability to operate.
Because it is classified as a necessary business expense, all of those interest payments reduce the total amount of taxable income in the form of tax deductions.
One important note. The interest tax shield is only applicable when the company’s earnings – specifically, earnings before interest and taxes (EBIT) – is larger than the actual expenditures on interest.
So, a company must be profitable before they can start benefiting from the interest tax shield.
Why Does the Interest Tax Shield Matter?
You might be wondering why this really matters. The interest tax shield is an important tool for both newer companies looking to raise capital efficiently and larger, established companies.
Companies can raise capital several ways, including:
- taking out loans,
- issuing debt, or
- issuing equity shares.
For companies, issuing equity shares can be rewarding and allow for very quick growth. However, dividends paid out to shareholders are not tax deductible.
Taking out loans from banks and other lenders might come with a higher interest rate. But all of the interest paid on those loans is tax deductible. This creates an interest tax shield.
For that reason, newer companies might see loans as a more efficient source of capital.
Larger companies can also benefit from carrying debt even though they may have larger cash stockpiles.
Apple is a well-known example of this. Despite having a cash pile of nearly $35 billion in September 2021, the company carried long-term debt of about $162 billion.
The debt allows for that interest to help with income tax deductions.
It’s important to note that excessive debt can be quite dangerous.
Companies can default or become insolvent if they’re unable to meet their interest expense or debt repayment obligations.
Interest Tax Shield Calculation
The tax shield is calculated simply by multiplying the total amount of interest paid by the corporate tax rate.
Mathematically, we calculate interest tax shield as…
Where refers to Interest Tax Shield, reflects the interest expense or payment (in dollars, pounds, etc), and represents the corporation tax rate.
Corporate tax rates () will vary from one country to the next but they typically tend to range between 20% and 35% for the most part.
Interest Tax Shield Example
Let’s consider a very simple example.
Suppose there are 2 identical companies, A and B. Both companies are identical in all aspects other than debt and interest payments.
Company A has 0 debt and 0 interest payments.
Company B has some debt and an interest expense of $10 million.
Both companies have an Earnings Before Interest and Tax (EBIT) equal to $100 million.
Without the tax shield, Company B’s interest payment is just an expense that decreases a firm’s profitability and hits its cash flow.
Now, suppose both companies operate in an economy where the corporation tax rate is equal to 20%.
Thanks to the interest tax shield, Company B can essentially save 20% of that $10 million, which amounts to a $2 million.
It’s best to compare the two cases individually starting with Company B.
With EBIT equal to $100 million, Company B’s Earnings Before Tax must be equal to $90 million.
And it’s Net Profit (profit after tax) will be equal to $72 million.
Company A’s EBIT is also equal to $100 million.
But the Earnings Before Tax would also be $100 million (since there’s no interest to pay).
Company A’s after tax income (Net Income) will be $80 million.
Sure, that’s greater than $72 million, but let’s think about the tax payable.
Company B’s tax bill would equate to 20% $90 million $18 million.
Company A’s tax bill would equate to 20% $100 million $20 million.
Thus, without the interest payment, the company A effectively pays $2 million in additional tax.
Higher Cash Flows to Investors
But perhaps you’re thinking, hang on a minute! Company A has a higher net profit. Surely that’s better?
Well, it depends.
If the metric of interest is profit, then sure. Company A is better (in this example).
If the metric of interest is cash flows on the other hand, then Company B is better.
Let’s see why this is true.
Suppose both companies use “cash accounting” (instead of accrual accounting).
And for simplicity, let’s assume that there are no messy accounting conventions distorting profit from cash flow.
The cash flows to Company A’s investors would equate to $80 million.
This is equivalent to the firm’s total profit (aka Net Income) of $80 million.
The cash flows to Company B’s investors on the other hand, would equate to $82 million.
This is equivalent to the firm’s:
- total profit of $72 million, and
- total interest payment of $10 million
Interest is paid to the firm’s debt investors (aka debt holders).
Thus, Company B’s investors as a whole earn more than the investors of Company A.
And this effect is driven exclusively by the interest tax shield.
Pretty powerful, isn’t it?
Does This Mean All Corporate Debt Can Be Good?
Companies are always trying to improve their edge not only by improving the products and services they bring to the market. But also in the tools that help increase their bottom-line profits as much as possible.
Debt is one such tool, but it’s not without flaws.
While debt can be a good thing as we’ve seen with the $2 million tax saving above, there are always cases where a company has too much debt on its books.
Further, although interest payments on debt are usually tax deductible, the debt still must be paid off. And the debt payments themselves aren’t usually tax deductible.
As highlighted above, unmanageably high interest and debt payments can force a firm into insolvency or bankruptcy.
Thus, despite the (powerful) theoretical capital structure concept of Modigiliani and Miller showing debt is better than no debt…
It’s important to remember that no debt is better than too much debt.
Are There Other Kinds of Tax Shields?
There are many kinds of tax shields available to businesses.
The most common one is perhaps the interest tax shield and the depreciation tax shield.
In truth, any tax deductible expense can be seen as a sort of “Tax Shield” in that it “shields” the business from tax.
And while these tax shields do mean governments receive lesser tax revenue…
It also means companies have more money available to reinvest back into the business for higher growth.
Are Interest Tax Shields Only For Corporations?
Corporations will generally be the ones to utilise interest tax shields, but individuals may have this tool at their disposal as well.
For instance, in many countries, the interest paid on your home mortgage is tax deductible.
This is a huge benefit for individuals since the home is usually the largest asset any one person will ever purchase.
Some countries may even allow interest paid on university tuition loans to be deducted from taxes.
Naturally, this is very much country-specific, but it’s fair to say that interest tax shields aren’t solely for corporations.
What’s Next – Interest Tax Shield
The interest tax shield can be an effective tool for companies looking to optimise their tax bill to allow greater reinvestment for growth.
That is because the interest paid on business loans can be counted towards a deduction on taxable income.
While the debt levels need to be managed strategically to avoid carrying too much debt…
There are plenty of examples of companies that carry large debt numbers but stay within a margin of safety to take advantage of the interest tax shield
Alright, that’s a wrap for this particular article. We hope you found it useful.