Interest on Equity versus Dividends: The Role of Shareholder Identity in Corporate Tax Avoidance

Purpose - This paper investigates whether the identity of the controlling shareholder is a determinant of the distribution of earnings (interest on equity vis-a-vis regular dividends) in a sample of Brazilian public companies. Theoretical framework - Through numerical exemplifications, we show that the cost of receiving cash payouts through interest on equity (IOE) is significantly heterogeneous across shareholders. We use this diversity to state the optimal distribution (from a tax standpoint) for each type of shareholder. Design/methodology/approach - We test the hypotheses using an unbalanced panel of 404 Brazilian firms over a 12 -year period. Our estimations use probit and tobit panel data regressions. Due to endogeneity concerns about ownership identity status, we also run regressions using lagged regressors, the Heckman two-step selection model, and matched samples. Findings - Consistently with ex-ante, tax-driven hypotheses, we find that the presence of institutional investors significantly increases cash payouts in the form of IOE vis-a-vis cash dividends, reducing overall taxation (firm-level plus investor-level) for the average firm. Smarter tax management through dividend policy is also a positive function of firm characteristics such as size and better corporate governance standards. Overall, our evidence suggests shareholders' identity influences payout policy through the taxation channel. Practical & social implications of the research - Although the literature discusses several possible explanations for the limited use of IOE payments in Brazil, we provide evidence that many firms may not enjoy the tax benefits of IOE precisely because the tax law discourages controlling shareholders from using it. Such evidence is also critical for policymakers since there is currently a controversial national debate on imposing a dividend distribution tax and eliminating IOE (Law Project n. 2337, 2021), in the so-called "second phase of tax reform." Originality/value -Unlike previous studies, we discuss the distribution of IOE from the perspective of both the beneficiaries (shareholders) and payers (investees) rather than the former or the latter alone. Furthermore, as a reflection of potential measurement problems, we create a variable that measures the ratio between IOE distributed and the maximum allowed by law (IOE_IOE*), which permits a more precise measurement of the size of the tax benefit obtained by each firm.