What is Depreciation Tax Shield?
Depreciation Tax Shield is the tax saved resulting from the deduction of depreciation expense from the taxable income and can be calculated by multiplying the tax rate with the depreciation expense. Companies using accelerated depreciation methods (higher depreciation in initial years) are able to save more taxes due to higher value of tax shield. However, the straight-line depreciation method, the depreciation shield is lower.
Depreciation Tax Shield Formula
Depreciation tax shield = Tax Rate x Depreciation Expense
If company XYZ has a depreciation expense of $50,000 and the tax rate is 30%, then the calculation of depreciation tax shied will be as follows –
Depreciation tax shield = 30% x $50,000 = $15,000
Example
Let us look at a detailed example when a company prepares its tax income 1) accounting for depreciation expense and 2) not taking depreciation expense.
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Case 1 – Taxable Income (with Depreciation Expense)
The tax rate considered in the example is 40%.
The Amount of Tax to be paid is calculated as –
- TAX to be Paid over Income = (Revenues- Operating Expenses-Depreciation-Interest Expenses) x tax rate
- or EBT x tax rate
We note that when depreciation expense is considered, EBT is negative, and therefore taxes paid by the company over the period of 4 years is Zero.
Case 2 – Taxable Income (not considering Depreciation Expense)
In Case we don’t take the Depreciation into account, then the Total Tax to be paid by the company is 1381 Dollar.
Why is Depreciation Tax Shield important?
- It helps in reducing Tax liability. In order to promote investment, for various socio-economic development Government provides a higher Depreciation Rate.
- Allowing a higher depreciation rate attracts the investors to invest their money in a particular sector. As a result, investors get TAX benefits. The depreciation rates vary from 40% to 100%.
- In order to boost renewable energy generation and to combat climate change, the government allows incentives to the investor to lower their tax expenses by allowing them to avail of accelerated depreciation benefit for investing the money in wind power and solar power projects.
How Accelerated Depreciation Works on Tax Savings?
Assumption – For 1MW Solar Power Plant
- Project cost (capital cost) to be 1000 Dollars.
- The depreciation amount to be 90% (10 % scrap value assuming)
- Book depreciation (on fixed assets) to be 5.28 %
- Tax depreciation rate to be 80% (under benefits)
- Effective tax rate (as per government) to be 33.99%
The Life of Solar Power Plant is considered as 25 Years, but in this example, we have considered the time period for 4 years only.
The booked Depreciation Tax shield is under the Straight Line method as per the company act. The net benefit of accelerated depreciation when we compare to the straight-line method is illustrated in the table below.
We note from above that the Tax Shield has a direct impact on the profits as net income will come down if depreciation expense is increasing, resulting in less tax burden.
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