A tax shield is the present value of future tax savings attributed to the tax deductibility of a particular expense in a company's P&L.
Usually the term in used in connection to interest on corporate debt (“tax shield of debt”).
Interest expense is, as opposed to dividends and capital gains, tax deductable, therefore the tax shield (being a benefit of debt financing over equity financing) is an important factor influencing the company's capital structure choice.
While academic research in general agrees on the importance of taxes for capital structure decisions, there is still a wide range of estimates of the magnitude of the tax shield. Empirical estimates for its value vary between 5 per cent and 15 per cent of corporate outstanding debt.
Research has identified besides the level of debt, the tax rate, credit risk, bankruptcy probability and the firm´s future financing policy (i.e. adapting future debt levels to changing economic conditions) as important variables influencing the value of the tax shield.
Some governments are concerned about the "excessive use" of corporate debt by certain investors, especially private equity investors. One potential strategy to influence corporate capital structure choices is to cut the tax deductibility of interest. By doing so tax authorities reduce the tax shield and remove a significant benefit of debt financing over equity financing.
In 2008 the German government introduced a regulation to limit the recognition of interest as tax deductable expense to 30 per cent of the firm´s current EBITDA (earnings before interest, tax, depreciation and amortisation).
In the current discussion on corporate tax regulations in the US this idea plays an important role as well. However, while obviously aiming towards incentivising PE investors to use less debt, it remains unclear whether this limitation will have a positive or negative effect upon private equity deal performance.
See Prof Schwetzler explaining tax shields in this video