What Is an Interest Tax Shield?

An interest tax shield is a term used to describe a tax break that involves deducting the interest paid on some portion of the income that is subject to taxation. Businesses as well as individuals may choose to utilize this type of shield as a means of choosing how to finance different purchases and projects, simply to maximize the amount of the deduction that can be claimed. When the amount of the interest paid in over the course of the tax period is significant, the interest tax shield may help to prevent the taxpayer from being classed in a higher bracket, saving even more money.

One of the easiest ways to understand how an interest tax shield functions is to consider an individual who currently holds debt in the form of a mortgage. In many nations, it is possible to claim a tax deduction based on the amount of interest that is paid to the lender over the course of the tax year. Depending on the current tax regulations that apply, all or a portion of that interest may be used to reduce the amount of tax liability that is owed on the income generated during that same tax period. The end result is that the interest tax shield, along with other deductions help to minimize the amount of taxes due for the period and may even help the homeowner to receive a tax refund.

In like manner, businesses can also employ the idea of an interest tax shield. Here, the decision usually involves deciding if a company project should be financed using loan capital or the capital resources that the business already owns. Depending on the amount of financing required and the nature of the loan arrangements, there is good chance that the amount of interest that is paid during the course of the tax year will be significant. Since that interest is considered deductible, it is used as a deduction that helps to offset some of the revenue gains incurred during the year. The end result is that the company retains more working capital and pays a lower amount of taxes.

In order to ascertain the benefits of the interest tax shield, it is important to determine what types of interest are actually deductible under current tax laws. Consulting with a tax professional will make it easier to identify relevant tax regulations and relate them to the interest paid during the tax period. From there, tables provided by the revenue agency can be used to determine what percentage of the interest can be used as a deduction.