3.29: Tax shields
“Tax shield” can refer to any factor within a company that helps to lessen the impact of normal taxes. The two most common tax shields affecting business valuation reports are:
- The present value of future capital cost allowances on existing capital assets, based on their tax cost (or “undepreciated capital cost”) at the valuation date.
- The present value of future capital cost allowances calculated on the difference between the fair market value and the tax cost of existing assets.
Tax shields provide a company with a “shield” against future taxes.
The first tax shield adds to enterprise value of the business by recognizing that future tax allowances have a positive present value.
The second tax shield contributes to the FMV of the tangible asset backing (TAB) of the company. It considers whether the depreciable assets would have a higher value if they were held outside the company, in which case their FMV would be the base for calculating tax allowances. This tax shield:
- adjusts the TAB down (tax shield lost) if the tax cost of the assets is lower than their FMV, given that future tax allowances within the company will be limited;
- adjusts the FMV of the TAB up (tax shield added) if the tax cost of the assets is higher than their FMV, i.e. it is better to leave the assets within the company and take advantage of the future tax allowances.
On a technical note, if the tax cost equals FMV (which happens when a company uses the same allowances for tax and depreciation), the tax shield will usually be “lost” due to the half-year rule for tax allowances. Many of the tax shields are timing differences.
Contact MVI for a more complete discussion of tax shields.