What is the Conduit Theory?

The conduit theory is an understanding that has to do with the taxation applied to an investment firm. Essentially, the conduit theory states that if the firm routinely passes interest, dividend income, and capital gains on to the client base and the shareholders of the firm, then the company should not be liable for taxes on those monies. Instead, the recipients of the funds should be liable for the taxes only, and not the investment firm as well.

An underlying principle of the conduit theory is the rejection of an action that effectively amounts to double-taxation on the funds involved. Since the investment firm does not hang on to the dividends or capital gains, the perception is that there is no long term benefit derived from those funds. As such, there is no reason for the investment firm to pay taxes on funds that do not remain at its disposal, and in fact are already subject to taxes that are imposed on the shareholders and clients of the firm. In short, the conduit theory holds that two different entities should not incur a tax liability on the same funds.

Because the conduit theory is all about the ability to avoid double taxation, several different types of investment companies have supported legislation to make this possible. Mutual fund companies are in support of the conduit theory, as are real estate investment trusts, or REITs. The idea is that the double taxation structure that is common to most types of businesses has more of an impact on these types of organizations. Whereas a retail or manufacturing business has means of generating resources to offset the double taxation that takes place, investment firms may be considered more limited in how they can draw on resources to cover the taxes involved.

There is no consensus on the fairness of the conduit theory. Supporters see the theory as making not only good business sense, but also common sense as well. Individuals and entities that oppose the concept of the conduit theory sometimes view the approach as providing investment firms and other forms of financial institutions with a favored status that is not merited.