The importance of tax shields | BrightOrange

Reading time 3 min. Bedrijfswaardering

Business valuation

The term ‘tax shield’ often comes up in business valuations. But what exactly is a tax shield and how can you use it to your advantage? BrightOrange provides a clear explanation.

What is the tax shield?

A tax shield refers to reducing taxable income by deducting allowable expenses, such as interest payments on debts, depreciation, and investments. These deductions reduce the amount of tax a company must pay. This has a direct impact on the company’s valuation. The tax benefit resulting from these deductions is called a ‘tax shield’.

Formula to calculate the value of the tax shield

The value of the tax shield can be calculated using the following formula:

What Is The Tax Shield = Deductible expenses x Tax rate

How does a tax shield work?

Suppose a company takes out a loan to finance new equipment. The interest payments on this loan are deductible from taxable income. These deductible interest payments reduce the company’s taxable income, resulting in lower corporate income tax. This difference in tax payments, achieved through the use of deductions, is the tax shield.

Tax shield example:

A company takes out a loan of €6,000,000 with an interest rate of 10%. The tax rate is 25%. The company pays annual interest of €6,000,000 x 10% = €600,000. This interest is deductible from the company’s taxable income. This gives the company a tax benefit of €600,000 x 25% = €150,000. In this tax shield example, the value of the tax shield therefore is €150,000.

Strategic use of tax shields

The effective use of tax shields requires a strategic approach. When making investment decisions, companies must carefully consider their financing strategy. Striking the right balance between equity and debt (solvency) plays a crucial role in this. For example, a relatively high level of debt can generate more tax benefits, but it can also entail risks, such as financial instability.

Increasing the value of the business

Shield tax offers an important advantage in reducing taxable profits and tax assessments. Not only can this reduce the tax burden and increase the value of the business, but it also allows “bonus” profits to be invested in business activities. By purchasing new assets such as buildings, equipment, or patents, the business can continue to grow. To minimize risks and take full advantage of shield tax, a carefully considered approach should be taken. BrightOrange can provide professional support in this regard.

Regulations

The tax authorities have introduced legislation and regulations to limit the use (and especially the abuse) of tax shields. For example, the earnings stripping regulation limits the deduction of net interest expenses to 20% of the company’s EBITDA, with a maximum of €1 million. In addition, there are rules that prevent companies from entering unreasonably high debts or transactions solely for tax purposes. These rules are set out in a European directive, the so-called general anti-abuse rule (GAAR). Within the Netherlands, this directive is applied based on the fraus legis principle. This applies if:

A structure serves solely to avoid tax and has no other fiscal significance (motive requirement);
The structure is contrary to the purpose and scope of the law (norm requirement).

If the court labels the legal act as fraus legis, the result is that the legal act performed is not taken into account for taxation purposes.

Conclusion

What is a tax shield? The tax shield is a powerful tool that, when applied correctly, can significantly increase the value of your company by reducing the tax burden. BrightOrange invites you to explore with our experts how this and other financial strategies can help your business move forward. Feel free to contact us or fill in our ‘Is my business ready for sale?’ tool and receive a free advisory report!

Stefan Koelewijn

Consultant