Regulation M

Regulation M, also known as Subchapter M, is an Internal Revenue Service (IRS) regulation that allows regulated investment companies to pass taxes from capital gains, dividends and interest distributions onto individual investors. Regulation M conforms to the 'conduit theory,' which states that investment firms should pass capitals gains, interest and dividends to shareholders in order to avoid double taxation by the company and the individual investors.

Regulation M is outlined in IRS tax code Title 26, beginning with Section 851. It applies to regulated investment companies. These companies have U.S. operations and are registered as investment companies as directed by the Investment Company Act of 1940. As defined by ’40 Act legislation, these companies can take numerous forms including mutual funds, exchange-traded funds (ETFs), real estate investment trusts (REITs) and unit investment trusts (UITs).

Regulated investment companies are given eligibility to pass through taxes to individuals under IRS Regulation M. Most regulated investment companies utilize this regulation to pass through distributions to shareholders for the purpose of avoiding double taxation.

Conduit theory suggests that regulated investment companies should utilize this eligibility for tax savings. Eligible investment companies serve as a conduit for certain distributions which are specific to investment company operations. Typically the conduit determines the distribution amounts which are characterized as capital gains, dividends and interest. Due to the unique structuring of investment company management, regulated investment companies can gain an incremental benefit from paying out distributions planned for shareholders. As a conduit, investment companies pass on specified distributions to shareholders and therefore are not required to pay portfolio taxes on these dispersed payouts.

For example, a mutual fund company serves as a conduit for investors, passing on dividends, interest and capital gains. Various distributions from a mutual fund are paid out throughout the year. Capital gain distributions are typically paid annually at the end of the year.

Suppose an investor owns a few shares of a mutual fund. The fund pays quarterly dividends and distributes an annual capital gains payout. For the year, the investor must pay taxes on all of the fund’s distributions regardless of whether or net the payouts are reinvested. Without Regulation M, the mutual fund company could potentially be subject to certain standard corporate tax rules which require it to pay taxes on capital gains. With IRS Regulation M, double taxation is avoided and taxes are only paid by the investor.