A company’s interest payments are tax deductible. That is, the interest expense paid by a company can be subject to tax deductions. Such a deductibility in tax is known as interest tax shield. For example, there are some cases where mortgages have an interest tax shield for the buyers as the mortgage interest is deductible on the income.
Companies normally want to reduce their tax liability as much as possible. Interest tax shields therefore encourage firms to finance their projects with debt, as the dividends paid to the equity investors are not tax deductible.
The valuation of the interest tax shield capitalizes the total value of the firm and it limits the tax benefits of the debt. As interest expenditures are tax-deductible, tax shields play an important role because the firms can receive benefits from the structuring of the arrangements.
The interest tax shield is positive when the Earnings Before Interest and Taxes (EBIT) is greater than the interest payment.
It is also notable that the interest tax shield value is the net present value of all of the interest tax shields.
Individuals can also benefit from tax shields. It is very useful when purchasing a home with a loan or a mortgage. In getting a house with a mortgage, the interests paid are tax-deductible. That means the person can get benefits from the interest payments, as it can reduce the taxable income. As a result, one can reduce the tax liability.
It is crucial to understand how interest tax shields work because it is considered as an essential part of business valuation. The interest tax shield that individuals and businesses can get vary from country to country. The benefits usually depend on the cash flow and the overall taxable rate of the taxpayer. Governments offer interest tax shields to encourage more investments for the companies and firms, as well as for the individuals.
Although interest tax shield offers tax benefits, many companies choose not to take the benefits on tax payments for the following reasons −
Too much debt can be a bottleneck, and
The tax shield may often come with a covenant.
Covenants are restrictions that are attached with the issuance of debt. In other words, companies must follow the restrictions while acquiring debt. In such cases, when the debt goes above the tolerable limit, it can hurt the company’s bottomline.
To offset the pressure of too much debt, companies may have to arrange funds by stopping already active projects which may hurt the company’s growth and profitability. Therefore, interest tax shields must be opted with caution.