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
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For eg:
Source: Depreciation Tax Shield (wallstreetmojo.com)
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.
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, EBTEBTPretax income is a company's net earnings calculated after deducting all the expenses, including cash expenses like salary expense, interest expense, and non-cash expenses like depreciation and other charges from the total revenue generated before deducting the income tax expense.read more 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 assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more) to be 5.28 %
- Tax depreciation rate to be 80% (under benefits)
- Effective tax rateEffective Tax RateEffective tax rate determines the average taxation rate for a corporation or an individual. For both, there is a similar formula only with variation in considering variables. The effective tax rate formula for corporation = Total tax expense / EBTread more (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.
| Time Period | Years | 1 | 2 | 3 | 4 |
|---|---|---|---|---|---|
| Book Depreciation | % | 5.28% | 5.28% | 5.28% | 5.28% |
| Book Depreciation Capital | Dollars | $52.08 | $52.08 | $52.08 | $52.08 |
| Opening | % | 100% | 60% | 12% | 2% |
| Allowed During the Year | % | 40% | 48% | 10% | 2% |
| Closing | % | 60% | 12% | 2% | 0% |
| Accelerated Depreciation | Dollars | $400.00 | $480.00 | $96.00 | $19.20 |
| Net Depreciation Benefit | $347.00 | $427.00 | $43.20 | $ (33.60) | |
| Tax Benefit | 33.99% | $118.01 | $145.21 | $14.68 | $ (11.42) |
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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