What is Regulation M?

Regulation M allows regulated investment companies to avoid double taxation by passing taxes from capital gains, dividends, and interest distributions onto individual investors. It is an Internal Revenue Service Regulation applied to all investment companies operating in the United States that are registered under the Investment Company Act 1940. According to this law, investments companies include exchange-traded funds, mutual funds, real estate investment trusts (REITs) and unit investment trusts (UITs).

How Does Regulation M Work? 

Regulation M is described in the Internal Revenue Code (IRC) Title 26, beginning at Section 851. Regulated investment companies can save on taxes by utilizing this regulation. According to the conduit theory, investment companies should pass capital gains, interest and dividends to shareholders for avoiding double taxation. Regulation M, also known as Subchapter M, conforms to this theory. Investment companies work as a conduit for such distributions. The distribution amounts are decided by these eligible investment companies working as the conduit. In the process, the capital gain, dividend, and interests are passed on to the shareholders and the conduit does not have to pay portfolio taxes on these payouts. The unique structuring of the management of such companies allows them to retain a cumulative benefit from these payouts to the shareholders. Mutual fund companies work as conduits and distribute the capital gain, dividends, and interests to the shareholders. While the capital gain distributions are generally disbursed once a year, other distributions are paid regularly during different times of a year. The shareholders of mutual funds receive the quarterly dividends and capital gain distribution at the end of the year. The shareholders are liable to pay taxes on these receivables, whether or not they reinvest the money. Regulation M makes sure only the investors need to pay the taxes on these distributions and not the companies.