Interest Tax Shields: Understanding Tax Deductions on Interest Expense

The term “interest tax shield” refers to the reduced income taxes brought about by deductions to taxable income from a company’s interest expenseInterest ExpenseInterest expense arises out of a company that finances through debt or capital leases. Interest is found in the income statement, but can also. For instance, there are cases where mortgages may have an interest tax shield for buyers since the mortgage interest is deductible against income.  One of the main objectives of companies is to reduce their tax liability as much as possible. Interest tax shields encourage firms to finance projects with debt since the dividends paid to equity investors are not deductible.

Valuation of the Interest Tax Shield

In the valuation of the interest tax shield, it capitalizes the value of the firm and it also limits the tax benefits of the debt. Interest expenses are considered to be tax-deductible, so tax shields are very important, as firms can get benefits from the structuring of such arrangements. The interest tax shield is positive when the EBIT is greater than the interest payment. It is also important to keep in mind that the interest tax shield value is the present value of all the interest tax shields.

Tax Shield for Individuals

Individuals can also take advantage of the tax shield. This is very useful when you want to purchase a home with a loan or a mortgage. In getting a house with a mortgage, the interest expenses are tax-deductible, which means that the person can get benefits from it, as it can offset against his or her taxable income. As a result, you can reduce tax liability.

It is important to understand how an interest tax shield works, as it is considered to be an essential part of business valuation. Each country varies when it comes to the interest tax shield that individuals and businesses can get. In the end, the benefits depend on the cash flow and the overall tax rate of the taxpayer. Governments provide interest tax shields in order to encourage more investments for companies and firms, as well as for individuals

Additional resources

To continue learning and advancing your career, see the following CFI resources

• Tax shieldTax ShieldA Tax Shield is an allowable deduction from taxable income that results in a reduction of taxes owed. The value of these shields depends on the effective tax rate for the corporation or individual. Common expenses that are deductible include depreciation, amortization, mortgage payments and interest expense
• Cost of debtCost of DebtThe cost of debt is the return that a company provides to its debtholders and creditors. Cost of debt is used in WACC calculations for valuation analysis.
• What is WACC
• What is financial modelingWhat is Financial ModelingFinancial modeling is performed in Excel to forecast a company's financial performance. Overview of what is financial modeling, how & why to build a model.