Tax shield - what is it and who can benefit from it?

Service-Tax

In order to run a business efficiently, entrepreneurs usually strive to maintain financial liquidity in the company and to take steps to contribute to tax optimization. Therefore, they undertake various activities aimed at creating a tax shield. We are dealing with the tax shield phenomenon commonly. It is used to minimize tax obligations in the company. Read what is a tax shield and who can benefit from it?

What is a tax shield?

The tax shield effect is a phenomenon consisting in lowering the amount of income tax through the use of foreign capital in financing the enterprise. Then, the income tax is reduced thanks to including directly in tax deductible expenses, expenses related to the use of external capital. Such expenses include, for example, interest on a loan, leasing installments and other fees related to leasing, as well as depreciation write-offs on fixed assets.

The tax shield is made up of expenses such as:
- leasing installments in operating leasing,
- leasing fees,
- interest on loan,
- depreciation.

Tax shield - who can benefit from it?

Not all entrepreneurs can benefit from the tax shield. Its application depends on the form of taxation of the enterprise. A prerequisite for the use of the tax shield is the settlement of income tax on general principles (according to the tax scale or with a flat tax).

On the other hand, the tax shield does not apply to enterprises settling their income tax with the use of a tax card or on the basis of a lump sum on recorded income. Because in the case of these two forms of taxation, the tax base cannot be reduced by the costs incurred in relation to the conducted activity. It is not possible to deduct them from the earned income.

Tax shield - how to calculate it?

The tax shield can be calculated according to the mathematical formula:

K = (1-P) * W.

where:
W - financial expenses

P - income tax rate

K - actual cost including the target

Thus, the difference in the amount of PW is the amount of the saved income tax. The value of the tax shield can also be calculated with the help of special calculators.

Tax shield and VAT deduction and depreciation

The amount of the tax shield is directly influenced by the method of deducting VAT from expenses incurred on the vehicle used in the company. In a situation where the taxpayer uses the vehicle for mixed use (private and business), then the expenses related to the vehicle are entitled to a 50% VAT deduction. On the other hand, the second half of VAT increases the net amount of the expenditure, and as a result it becomes a tax deductible cost.

However, in the case of a tax shield in the form of depreciation, its impact on tax liabilities depends on the method and rate of depreciation used and the initial value of the fixed asset. The depreciation rate is determined based on the category of the fixed asset.

Example 1.

The entrepreneur settles income from activity using a flat tax. During the last year, it achieved revenues in the amount of PLN 320,000, while the value of costs incurred in the same period is PLN 280,000. The profit achieved is therefore 40,000, which is the taxable amount. As a result, the income tax payable amounts to 40,000 * 19%, i.e. PLN 7,600.

Let us consider examples of the use of the tax shield effect:

  1. A passenger car under operating lease, which will be used in a mixed manner, and the total sum of installments in the net amount + 50% of non-deductible VAT is PLN 18,000 annually. Leasing installments will directly increase the amount of costs incurred in the enterprise. As a result, this will reduce the tax base to PLN 22,000. Therefore, the income tax would amount to 22,000 * 19%, i.e. PLN 4,180.

Calculations:
PLN 320,000 - (PLN 280,000 + PLN 18,000) = PLN 320,000 - PLN 298,000 = PLN 22,000 - tax base
PLN 22,000 * 19% = PLN 4,180 - tax payable.

As a result of including in the costs of leasing installments, the amount of tax payable decreased by PLN 3,420 (PLN 7,600 - PLN 4,180 = PLN 3,420).

  1. Entering a used vehicle to the fixed assets register, worth PLN 50,000 PLN, which was purchased on credit.
    A taxpayer may apply a straight-line depreciation rate of 20% per annum, while in the case of cars used for at least 6 months before entering into business, an individual depreciation rate may be applied, which is 40% per annum.

The value of the depreciation charges being the tax cost for the entire year would then be: 50,000 * 40%, or PLN 20,000. After increasing the tax costs, the tax base would be: 20,000, and the tax value: 20,000 * 19%, i.e. PLN 3,800.
The value of the tax base is also influenced by bank interest, which will additionally reduce the income tax liability.

Calculations:
PLN 320,000 - (PLN 280,000 + PLN 20,000) = PLN 320,000 - PLN 300,000 = PLN 20,000 - tax base
PLN 20,000 * 19% = PLN 3,800 - tax payable.

Depreciation charges will reduce the value of income tax by PLN 3,800 (PLN 7,600 - PLN 3,800 = PLN 3,800).

As can be seen in the attached example, the tax shield used in the form of expenses financed from external funds, such as leasing, has a clear impact on reducing income tax.

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