Subchapter M

Subchapter M, also called the “conduit rule,” 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.

A fund’s NII can include returns earned 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 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 tax responsibility to shareholders. For example, assume a fund realizes a $20 capital gain. If the fund passes through that $20 capital gain to its investors, the shareholders (not the fund) are assessed the taxes on the gain.

This setup can feel unfair at first, but it helps protect shareholder value. Shareholders benefit when a fund performs well, and a fund’s net asset value (NAV) would fall if the fund had to pay substantial taxes, reducing the value of shareholders’ investment.

Also, many individual investors may pay lower (or no) taxes on these distributions:

First, many investors are in lower tax brackets than large funds, so less tax may be paid on the same returns.

Additionally, some investors hold mutual funds in tax-sheltered retirement accounts. These investors generally won’t pay taxes on NII received from the fund while it’s in the retirement account. 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.