Every law firm’s managing partner knows that the key to success is having sufficient capital to fund the daily activities of his/her firm and to fuel future growth.
The are only two forms of capital – debt and equity. Very simply, debt is a loan to a firm which is repaid with interest over a fixed time period. Equity is a partner’s investment into the firm for a stake in future profits over the period in which the shareholding is held.
While the distinction between debt and equity might seem trivial, the financial consequences of how you choose to structure your law firm’s capitalisation and balance sheet is significant.
By introducing debt onto your firm’s balance sheet, you benefit from something known as the Interest Tax Shield. By shielding a portion of your taxable income with interest payments, you are able to save cash flow each month, thereby increasing the value of your firm.
In this article we shed light on the powerful concept of a Tax Shield and the tax deductibility of interest expenses.
What is The Interest Tax Shield?
A Tax Shield is the reduction in tax that results from taking an allowable deduction from taxable income. Section 24J of the Income Tax Act of 1962 states that interest expenditure incurred in the production of non-exempted income and for the purposes of trade is deductible.
Therefore, the Interest Tax Shield is a benefit provided by South African tax law to benefit those who use debt to fund their business growth.
Put simply, if your legal practice is incorporated, the South African government will pick up 28% of your interest bill each month.
Calculating the Tax Shield
Calculating the Interest Tax Shield can be simplified by using this formula:
Interest Tax Shield = [Interest Expense] X [Tax Rate]
The After-Tax Interest Rate including the benefit of the Tax Shield is:
After Tax Interest Rate = Interest Rate X [1 – Tax Rate]
As an example, if your legal firm has a working-capital loan of R1 000 000 which incurs interest of 20% per annum, your tax shield would be R56 000 each year. This is an extra R4 666 per month in your pocket that would otherwise have been paid over to SARS.
Stated differently, the After-Tax Interest Rate in now only 14.4% per annum after the tax saving. This is 5.6 percentage points lower than the rate quoted by your bank or specialist credit provider.
Alpha Beta Attorneys Inc is a well-established law practice specialising in commercial litigation and family law. Due to the firm’s excellent reputation and convenient location, it has been inundated with requests to open a conveyancing division.
Mr. Labuschagne, the owner of the firm, has calculated that a new conveyancing division would cost R1.2 million to set up. This includes extending his current office space as well as paying salaries for new staff until the division becomes profitable.
Mr. Labuschagne is considering 2 options to fund this business growth:
- Labuschagne could borrow the necessary funds in his personal capacity by accessing additional funds in his home loan. He would then invest the proceeds directly into his practice OR
- Alpha Beta Attorneys Inc could borrow the funds directly through a working-capital loan.
Only the second option is eligible for the interest tax shield. Assuming an interest rate of 15% and a tax rate of 28% in both cases, the after-tax interest rate in option 2 is only 10.8%.
This tax benefit equates to a saving of R50 400 per annum. Alternatively, a higher capital amount of R1.66 million could have been borrowed at the same after-tax cost or the identical loan could have been repaid over a shorter period.
It is critically important how you structure the funding of your legal firm. You should consult your accountant or a registered tax professional beforehand to amplify the benefits of the interest tax shield.
Disclaimer: This article is for educational purposes only and should not be misconstrued as financial or tax advice. Consult an accountant or registered tax practitioner for advice specific to your financial situation.