The tax shield is an important factor in the success of a business. Managers can increase the value of the business by using the tax shield opportunity. This is because the tax shield contributes to an increase in the net cash flows coming into the business and therefore to an increase in the value of the business.
Businesses aim to maximize their revenues and minimize their costs. For this purpose, managers make important decisions about many issues such as design, production, distribution, product listing, advertising, customer relations, pricing, taxes. Each decision directly affects the competitive position of the business in the market. Tax shield is one of the most important factors to consider in terms of managing tax costs. Thanks to the tax shield, businesses reduce the tax base they have to pay.
What is a Tax Shield?
Businesses pay taxes depending on their income and the tax rates to which they are subject. When calculating the tax base, some transactions of businesses are deducted from the gross income amount. This reduces the amount of tax payable by businesses. The tax shield represents this reduction in the amount of tax payable. Although the tax shield is applied in many countries, the items to be deducted from gross income may differ on a country-by-country basis. This variation stems from different country perspectives on the activities that are deductible from taxable income. When governments allow certain items to be deducted from the tax base, there is an incentive for businesses to engage in those transactions. As a result, businesses that want to benefit from the tax shield prefer those transactions. For example, a regulation that allows the deduction of loan interest from the tax base but does not allow the deduction of equity from the tax base directly affects the capital composition preferences of enterprises. Thus, an enterprise may choose to benefit from the tax shield by evaluating other pros and cons of borrowing.
The size of the tax shield is determined by the size of the transactions that can be deducted from the tax base and the tax rate. The larger these transactions and tax rates are, the greater the degree to which the entity benefits from the tax shield.
Tax Avoidance versus Tax Evasion
A tax shield is a purely legal possibility and legally allows a business to pay lower taxes. In this respect, it should not be confused with tax evasion. The tax shield allows the tax base to be determined lower within the framework of the items permitted by the legislation. Therefore, it can also be expressed with the term tax avoidance. On the other hand, tax evasion is completely outside the framework allowed by law. Practices such as not paying taxes, underpaying taxes are examples of tax evasion. Tax evasion such as concealing, not reporting or underreporting taxable transactions may result in criminal consequences for the related enterprises.
Tax Shield and Tax Administration in the United States
As stated above, each country determines the scope of tax deductible transactions differently within the framework of certain priorities. The US also has its own regulations in this respect. According to these regulations, the following transactions are deductible from the tax base and constitute a tax shield for businesses:
- Depreciation
- Loan Interest
- Accident and Disaster Losses
- Interest on Mortgage Debt Securities
- Health and Dental Treatment Expenses
- Donations and Aids
- Work Related Training Expenses
- Using the Home for Business
- Using the Car for Business
- Business Travel Expenses
The transactions listed above are deductible from gross income. These transactions may arise due to the nature of the business without any prior planning. The important point here is to plan these transactions in advance by considering the tax shield effects and to determine the activities within this framework.
The tax shield is an issue that should be evaluated within the framework of the tax planning process. Accepting taxes payable as data is a handicap for businesses. Because taxes to be paid should be a part of tax planning and decision-making processes. Taxes are an important expense item in the budgets of enterprises. Therefore, business managers should make a detailed tax planning before making certain transactions. Rather than considering taxes as a fixed cost item, managers should evaluate business activities together with the tax consequences of these activities. In this way, the preferences of businesses for their transactions may change.
Undoubtedly, the tax shield should not be considered as the only factor in strategic decisions. However, its contribution to the business should also be taken into consideration in decision-making processes. Because, thanks to the tax shield, businesses can increase their net cash flows to the business by taking advantage of the opportunity to pay lower amounts of tax. This increases the value of a business or a project.
In conclusion, the tax shield is an important factor affecting the strategic choices of businesses such as capital composition (debt-equity), depreciation methods (direct-accelerated), and whether to make donations or not. Therefore, tax expenses should be planned in advance and the tax shield effect should be taken into account to achieve a higher enterprise value.
Make the Most of Tax Shield Opportunities with Sky Accounting
Sky Accounting provides professional accounting and tax advice and support services to businesses. Based in New Jersey, Sky Accounting has a well-trained and experienced team to help businesses grow healthily. Assessing the tax shield opportunities of businesses is one of the services Sky Accounting Consulting Company provides. Sky Accounting offers business-specific solutions, taking into account the specific situation and needs of each business individually. Thus, businesses can proactively determine their positions and organize their activities in advance to minimize tax expenses.
You can find all the services offered by Sky Accounting Consulting Company here.