Billions and basis points: Vanguard vs. IRS? (Updates)

(Updated) If the IRS agrees with David Danon, the former Vanguard Group tax lawyer who says the company sets aside billions in a "contingency reserve" that ought to be taxed (or credited to investors), and sets its fund service charges artificially low to avoid income tax liability: How much might Vanguard have to pay? And will that affect Vanguard shareholders?  (More on corporate "transfer pricing" income tax disputes here and here,  Internal Revenue Code here, more here, PwC view here.)

1) In his essay, "Too Big to Tax?", and in this paid-expert report for Danon, University of Michigan Law School Prof. and tax scholar Reuven Avi-Yonah last year argued the company could owe $35 billion in U.S. income taxes and penalties. He finds this by comparing Vanguard fees to average mutual-fund industry fees as calculated by Morningstar Inc. That fed scare headlines in corners of the online financial media, asking if Vanguard could survive such charges. (My column on Avi-Yonah's report here.)

2) In a December post subtitled "Not So Fast," University of Chicago law school assistant professor Daniel Hemel dug deeper into Morningstar data and sub-categorized fees by fund type, noting how much cheaper the index funds that account for a disproportionate part of Vanguard's funds are typically priced, by Vanguard's rivals, too. He estimated Vanguard could owe, tops, $10 billion in back taxes and fees. He expected Vanguard might have to raise fees modestly, but would survive.

3) Hemel is updating his analysis, noting, "It would be entirely legitimate for Vanguard to raise arguments about policy and purpose," and for the IRS to consider those arguments: "I don't think the case is an easy one." He caveats the value of his own analysis: "Brilliant lawyers devote entire professional careers to section 482 [transfer pricing and taxes]. I am a first-year assistant professor at a law school.  If I were Jack Bogle seeking expert advice on the subject, I would not hire Daniel Hemel." With that warning, here are Hemel's Vanguard scenarios:

- Contingency reserve: "Assume, for the sake of argument, that Vanguard owes corporate income tax on $3.2 billion in undeclared income [see "SEC filings" note below], plus a 40% penalty.  Multiply 35% [the top federal corporate income tax rate] by $3.2 billion, and then multiply the resulting figure by 140% [adding in penalties), and you get $1.568 billion.  Divide that by Vanguard's assets under management, which are roughly $3.2 trillion [$3.4], and you get 0.05%. So, worst-case scenario, we're talking about a one-time charge of 5 basis points for the contingency reserve..."

- Transfer pricing: "The $10 billion [Hemel's December] figure for back due taxes and penalties is on the extreme high end, and even that translates to only [about] 30 basis points." $5 billion-ish is "more realistic," if IRS were to pursue. (In a forthcoming article for Tax Notes, Hemel comes up with a similar figure ($5.4B) "using the comparable-profits method and Casey Quirk data on profit margins.") Either way, that translates to a "one-time charge of [about] 17 basis points" on Vanguard customers.

To reduce future tax liability, "Vanguard could likely restructure itself such that the investment management company is an LLC taxed as a partnership, in which case it would owe no federal corporate income tax."

- Bottom line, for Hemel: "As an individual investor, I would not move my money due to concerns about Vanguard's potential tax bill. Vanguard may be guilty of a tax foot fault [tennis term -- a relatively minor rules error] with respect to the transfer pricing issue -- a foot fault it likely could have avoided through an alternative structure." But even a high-end "17 basis point charge should not keep anyone except for John Bogle awake at night."

4) Also last fall, Vanguard, in footnotes to a string of SEC filings, began acknowledging that its mutual funds owed the company more than $3 billion in unpaid fees to cover costs "such as deferred compensation/benefits and risk/insurance costs." Danon's lawyer, Stephen Sorensen, said this money ought to be considered taxable income -- or, possibly, shareholder assets. Vanguard has not done either, leaving it open to IRS and SEC sanction, Sorensen says. Vanguard says it has followed the law.

5) Danon hopes the IRS and states will collect and he'll get a whistleblower's cut. As I reported here, Texas last year awarded Danon $117,000 for helping the state collect back taxes from Vanguard. Applying the formulas Texas uses to tax businesses and reward informants, this implies Texas found more than $200 million in Texas income which Vanguard should have paid taxes on. If, if, if: should other states find Vanguard has failed to pay taxes on income corresponding to their relative size/Vanguard in-state clientele, and the IRS piles on, Vanguard could owe $1 billion or more in taxes on over $3 billion in previously untaxed income.

6) Last weekend the New York Times published this column, defensive of Vanguard. I called one of the scholars briefly quoted, David Schizer, dean emeritus at Columbia University law school (and a member of the board that controls the Inquirer) and invited him to expand.

Schizer told me: "I don't think the entity 'managing' an index fund adds much economic value [or tax basis]. In a hedge fund, or a mutual fund with an actively managed portfolio, the fund managers are supposed to add value by analyzing market information and making judgments about what to hold, what to sell, what to add, etc. In that circumstance, they can be expected to charge a significant fee, so there is economic value added there, which 482 [the part of the federal tax code dealing with pricing between affiliates, like Vanguard Group and its funds] can tax.

"But with an index fund, in which the strategy is to replicate a well known index, the 'manager' isn't managing in the same way. The value added is quite minor, and in a competitive market the profit could be competed down to zero (or at least to quite a low level).

"That's why I said to [the Times columnist] that '482 is supposed to capture economic reality, not distort it.' In the same way, we would not want to use data about Pfizer or Merck's patent revenue to argue that a generic pharmaceutical firm, which has no patents, has to include patent income under 482..." -- Of course, Vanguard does have managed funds. -- Indexed funds are roughly 2/3 of Vanguard assets; under Schizer's analysis tax damage could be lots less than Avi-Yonah's estimate.

7) Indeed, Vanguard says it's feeling pressure to cut index fund fees to compete with rival firms; the company is even rolling out 1 basis point funds for very large institutional investors, as Dan Wiener of the Independent Adviser for Vanguard Investors newsletter noted in a recent update; the company might claim there is price competition for large-scale indexed funds and that its prices are thus market-level. (Update: more on this in my column in the Feb. 14, 2016 Inquirer here.)

But even with that competition, Vanguard still believes it can keep overall fees lower than its rivals, spokesman John Woerth confirms. -- Danon says the only way it can do that is to keep avoiding income taxes. 

8) Isn't Vanguard a cooperative/mutual/nonproit? Yale Law School Prof. John Morley addressed this question in this 2014 Yale Law Review paper, Separation of Funds and Managers, concluding that John Bogle is wrong about the nefarious nature of the "separation of funds and managers" -- but correct that Vanguard's "unique" arrangement does help clients -- while also making life easier for Vanguard managers. Excerpts:

"The Vanguard management company is a Pennsylvania corporation and each of the Vanguard funds is a distinct legal entity. Vanguard is unique, because the management company has issued its common stock to the funds that the management company serves, rather than to investors. In other words, Vanguard is technically owned by its funds.

"Vanguard thus claims—with the widespread agreement of academics and the public—to be a kind of client-owned co-op or mutual company.... Vanguard nominally combines the ownership of the management company and the funds by placing the management company's ownership in the hands of the funds... Vanguard's founder, Jack Bogle, is a vigorous critic of the separation of funds and managers.And Vanguard itself has built its branding partly on the notion that its corporate structure uniquely aligns its interests with those of fund investors.

"In reality, however, Vanguard is not meaningfully different from any other mutual fund management company. Practical circumstances and contractual devices deprive Vanguard's fund investors of any meaningful residual control and residual earnings rights.

"In economic reality, therefore, Vanguard investors are not truly the "owners" of the management company any more than the fund investors in any other mutual fund complex are.

"Vanguard fund investors' right to residual control over the management company is meaningless because fund investors have redemption rights. Fund investors will never actually use their rights to vote in the management company, because they will almost always prefer instead just to redeem. In other words, fund investors will never exercise control rights over the management company for the same reasons they will never exercise control rights over the funds.

"Vanguard's fund investors also have no meaningful right to claim the management company's residual earnings. At the time the management company starts its funds, the management company designates the fund's board. The board then causes each fund to sign agreements drafted by the management company that expressly give the management company essentially unlimited discretion to allocate costs among the various funds. The board of the management company can allocate costs without regard to the number of shares each fund owns in the management company and without regard to the amount of costs each fund actually generates.

"As a practical matter, this system deprives the funds and their investors of any real entitlement to Vanguard's profits. Vanguard can arbitrarily determine the financial benefit any particular fund receives from the management company by simply manipulating the portion of costs the fund must pay and the portion of resources it receives. Vanguard rarely distributes profits—it claims that its costs exactly equal its revenues—but even if Vanguard did distribute profits, it could offset or enhance any particular fund's dividends by simultaneously allocating the fund an increased or reduced share of costs.

"This makes Vanguard very different from true customer-owned co-ops and mutuals, such as agricultural and grocery supply co-ops. In these organizations, dividends must be paid out at regular intervals according to strict formulas based on share ownership and patronage.

"It is thus clear that Vanguard is not truly owned by its customers.

"So then who are its real owners? That is not so clear. One possibility is that Vanguard might not have any owners. It may be a kind of autonomous commercial nonprofit, sort of like a hospital.

"To be precise, Vanguard is not actually a nonprofit under the tax code or state law. But it purports to operate its funds "at cost" and so may functionally approximate a nonprofit.

"Alternatively, perhaps Vanguard is functionally owned by its employees and senior executives. Vanguard's employees and senior executives apparently exercise a high degree of influence inside of Vanguard, and it is possible that Vanguard's profits are being paid to its senior executives in the form of large salaries and other perks, even though these executives lack formal residual earnings rights. More formally, Vanguard's employees participate in a profit-sharing program that actually grants them residual earnings rights.

"To be clear, the point of this discussion is not to say that there is some scandal in Vanguard's structure. To the contrary: Vanguard's fund investors actually benefit from Vanguard's de facto separation of funds and managers. Vanguard's fund investors would be much worse off if they truly did own Vanguard.

"If the fund investors exercised meaningful control rights over the management company, then investors in the various funds would use their control rights to tear Vanguard apart by fighting over conflicted resources. And if the fund investors had real exposure to Vanguard's profits, then they would be forced to bear the risks of those profits. Thus, the lesson of Vanguard is that the separation of funds and managers is so useful that not even Vanguard can live without it."