Subchapter M, also called the “conduit rule,” is a tax rule that lets certain funds avoid being taxed at the fund level. To qualify, a fund must distribute at least 90% of its net investment income (NII) to shareholders.

In practice, most funds distribute about 98%-99% of NII by year-end. NII generally includes returns the fund earns on the securities in its portfolio, such as:

• Cash dividends from equity securities
• Interest income from debt securities
• Realized capital appreciation (gains)*

*A realized gain occurs when a security is sold for more than its purchase price. For example, a fund buys a stock at $50 and later sells it at $70. That $20 increase is a realized capital gain. If the fund still holds the security, the gain is unrealized. Only realized gains are considered for NII tax rules.

When a fund distributes NII, it passes the tax responsibility to shareholders. For example, suppose a fund realizes a $20 capital gain. If the fund distributes that $20 gain to investors, the shareholders (not the fund) are assessed taxes on the gain.

This can feel unfair at first, but it generally benefits shareholders overall. Shareholders gain when a fund performs well, and a fund’s net asset value (NAV) would drop if the fund had to pay substantial taxes, reducing shareholder value.

Also, many individual investors pay lower (or no) taxes on investment returns:

• Many investors are in lower tax brackets than large funds, so less tax may be paid on the same returns.
• Some investors hold mutual funds in tax-sheltered retirement accounts. These investors won’t pay taxes on NII received from the fund. We’ll cover this in more detail 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 qualify under Subchapter M are called “regulated” funds.