What is Conduit Theory?

Conduit Theory, which is also known as pipeline theory, is a financial theory that suggests that companies or firms which transfer all capital gains, interests, and dividends to its shareholders needn't pay corporate tax at the highest level, unlike regular firms and establishments. Many mutual funds qualify as conduits (a term which is used to denote companies that apply this theory) as they are regulated investment companies. Being a regulated investment company automatically grants an establishment the conduit status, thus making it exempt from taxes at corporate level.

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How Does Conduit Theory Work? 

Conduit theory is based on the suggestion that companies that transfer all their capital gains, interests, and dividends to major and minor shareholders are considered to be pipelines or conduits. These companies usually serve as investments corporations rather than as manufacturers, as they generally do not produce goods and services. Dividends and gains from such firms are automatically passed down to investors just like in the case of financial establishments like banks and mortgage investment firms. The investments are generally held in a managed fund. Conduits generally transfer untaxed income to investors as they're merely investment channels and do not have a product of their own. Investors who are eligible for income taxes are then required to cover the tax amount, thus these corporations wont have to pay for tax since they're typically not generating any income for themselves. While regular companies in the retailing and manufacturing sectors are subject to double taxation, conduits are free from taxes at corporate levels. Double taxation, in this case, requires the company to pay its corporate taxes, and also for investors to pay their income taxes on dividend and capital gains received. Double taxation has become an issue of debate in finance as it somewhat looks like a hoax concept for investors and firms.

Different Conduit Establishments

A great deal of mutual funds typically qualify for the conduit status and they are generally tax exempt as regulated investment companies. Other companies which are not regulated investment firms can also qualify for conduit status if they meet the requirements of a limited partnership, limited liability, and an S-corporation. Firms who meet any or all of the requirements above are typically exempt from income taxes. An example of an S-corporation in this case would be Fidelity, one of the biggest financial service provider who filed for conduit status in 2007. Any S-corporation, regardless of size and other factors is automatically free from tax deductions. Other examples of firms that can claim conduit status are real estate investment trusts (REITs) as they possess special provisions which allows them to taxed only as partial conduits. In some cases, REITs are permitted to deduct dividends and capital gains earned and transferred to shareholders and investors so that they can be able to pay for taxes at corporate levels.

Mutual Funds Conduit Theory

All, or almost all mutual funds are granted the status of regulated investment companies upon request, and this allows the to benefit from tax exemptions as conduit firms. It is basically essential for these mutual funds as they are required to pass all income gains and dividends to shareholders and investors. In mutual funds, fund tax expenses are generally controlled by fund accountants. Mutual funds which are granted tax exemption status would greatly benefit from lower operating expenses per annum from shareholders and investors. Tax exemption status are also displayed on mutual fund reporting documents.