Depreciation tax shield definition
/What is a Depreciation Tax Shield?
A depreciation tax shield is a tax reduction technique under which depreciation expense is subtracted from taxable income. The amount by which depreciation shields the taxpayer from income taxes is the applicable tax rate, multiplied by the amount of depreciation.
When the Depreciation Tax Shield is Most Effective
The use of a depreciation tax shield is most applicable in asset-intensive industries, where there are large amounts of fixed assets that can be depreciated. Conversely, a services business may have few (if any) fixed assets, and so will not have a material amount of depreciation to employ as a tax shield.
The tax shield concept may not apply in some government jurisdictions where depreciation is not allowed as a tax deduction. Or, the concept may be applicable but have less impact if accelerated depreciation is not allowed; in this case, straight-line depreciation is used to calculate the amount of allowable depreciation.
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Example of the Depreciation Tax Shield
Alfalfa Corporation has a tax rate of 21%. The amount of depreciation that it can deduct is $100,000. Based on this information, its depreciation tax shield is $21,000.
Impact of Accelerated Depreciation on the Depreciation Tax Shield
Anyone planning to use the depreciation tax shield should consider the use of accelerated depreciation. This approach allows the taxpayer to recognize a larger amount of depreciation as taxable expense during the first few years of the life of a fixed asset, and less depreciation later in its life. By using accelerated depreciation, a taxpayer can defer the recognition of taxable income until later years, thereby deferring the payment of income taxes to the government.
Accounting for Tax Shield Depreciation
In organizations that outsource the preparation of their tax returns, the tax return preparer may be charged with maintaining a separate list of depreciable assets, for which the preparer calculates the most aggressive allowable accelerated depreciation for inclusion in tax returns. Meanwhile, the company maintains its own depreciation calculations for financial statement reporting, which are more likely to use the straight-line method of depreciation. This alternative treatment allows for the use of simpler depreciation methods for the preparation of financial statements, which can contribute to a faster closing process.