Subchapter M, also referred to as the “conduit rule,” allows funds to avoid taxation. This tax-based rule requires funds to distribute at least 90% of their net investment income (NII) to shareholders to qualify. In reality, most funds distribute upwards of 98-99% of NII to shareholders by the end of the year, which includes any of the following returns acquired on the securities in a fund’s portfolio:
Cash dividends from equity securities
Interest income from debt securities
Realized capital appreciation (gains)*
*A realized gain occurs when a security is liquidated at a profit. For example, a fund purchases stock at $50, then sells it at $70. This is a $20 realized capital gain. If the security remains unsold, the gain is unrealized. Only realized gains are considered for NII tax rules.
When a fund distributes NII, it passes the taxation to its shareholders. For example, let’s assume a fund realizes a $20 capital gain. If the fund passes through the $20 capital gain to its investors, the shareholders are assessed the taxes on the gain.
This may seem unfair, but it’s best for everyone. Remember, shareholders benefit when a fund performs well. A fund’s net asset value (NAV) will fall if the fund is required to pay substantial taxes, causing shareholders to lose value.
On the other hand, many individual investors will pay lower or no taxes on investment returns. First, most investors are subject to lower tax brackets than large funds, effectively allowing less tax to be paid on the same returns. Additionally, some investors own mutual funds in tax-sheltered retirement accounts. These investors will not pay taxes on NII received from the fund. We’ll learn more about this in the retirement plans chapter. For now, assume investors do not pay taxes on dividends or capital gains distributions received in retirement accounts.
Funds that engage in Subchapter M are called “regulated” funds.
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