Tax Shield
A reduction in taxable income through deductible expenses like interest, depreciation, or losses, providing cash flow benefits by decreasing tax payments.
Tax Shield
A reduction in taxable income created by deductible expenses such as interest, depreciation, amortization, or operating losses, providing cash flow benefits by decreasing tax payments.
For instance, a company with a $1 million loan at 6% interest would pay $60,000 in annual interest. If subject to a 25% tax rate, this interest expense creates a $15,000 tax shield ($60,000 × 25%), effectively reducing the after-tax cost of borrowing to 4.5% rather than 6%.
Tax shields represent the tax savings generated by deductible expenses, calculated by multiplying the expense by the applicable tax rate. Common tax shields include interest on debt (making debt financing less expensive after tax), accelerated depreciation methods (generating larger deductions in early years), net operating loss carryforwards, and pension contributions. In corporate finance, tax shields factor into capital structure decisions, as debt’s interest tax shield reduces its effective cost compared to equity financing. The value of tax shields depends on maintaining taxable income and stable tax rates, making them less valuable for companies with persistent losses or in jurisdictions with changing tax policies.