Following up on my previous posts (links below): CBS News, Vanguard Investors, Your Fund Fees Could Quadruple:
There may be trouble brewing in Bogle-land
Fans of Jack Bogle, the legendary Vanguard Group founder, may be in for an unwelcome surprise: The mutual fund giant is facing claims that it doesn't charge enough for its management services.
Yes, you read that correctly. According to legal and regulatory claims from former Vanguard employee David Danon, the fund company's famously low fees are allegedly the result of an illegal tax strategy.
The potential fallout, according to a tax expert [Reuven Avi-Yonah] who is working with Danon, is a bill from the IRS for back taxes of up to $34.6 billion and, for Vanguard investors, the specter of much higher fees. The typical expense ratio for Vanguard funds, which now stands at an ultralow 0.18 percent, could more than quadruple to as high as 0.82 percent, according to the tax expert's assessment. ...
Danon also stands to reap more than $10 billion because the law allows a successful tax whistleblower to collect as much as 30 percent of whatever the IRS collects.
He may seem like an unlikely whistleblower: a graduate of Fordham law school who went on to work at prominent New York law firms Sullivan & Cromwell and Cleary Gottlieb. After joining Vanguard as a tax attorney in 2008, Danon noticed that the company handled its international funds differently than its U.S. funds, said attorney Stephen Sorensen of law firm Thomas Alexander & Forrester, who represents Danon.
The overseas funds were pricing their services at what tax law calls "arm's length," which is required when affiliates of the same company conduct business dealings with each other, Sorensen said. Under the tax law, transactions between affiliates or a corporation and its shareholders can't be brokered at rock-bottom prices because it can allow those companies to sidestep taxes.
"He said, 'Why is Vanguard not doing that domestically?' That's when he started asking questions, and that led to him getting terminated," Sorensen said. ...
Others say Danon's argument has some meat. Vanguard could be on the hook for $34.6 billion in past-due federal taxes from 2007 to 2014, according to a report prepared for the plaintiffs in September by Reuven Avi-Yonah, a University of Michigan tax law professor. Avi-Yonah, who has also taught tax law at Harvard and consulted for groups ranging from the U.N. to the U.S. Treasury, is working with Danon on the case.
While the heart of Danon's allegations are complex, the situation spins out of the unusual way Vanguard was structured when it was founded in the 1970s. Bogle wanted the company to be set up differently than other fund management firms because he believed many fund managers had an inherent conflict of interest between making profits for their company shareholders versus their fund investors. ...
Vanguard charges for the advisory services it provides to its mutual funds, but it prices them "at cost," which is a feature the company promotes in its marketing literature. Danon contends that's not allowed under U.S. tax law, given that both federal and state tax laws require affiliated companies to negotiate "arm's length" prices -- meaning the same amount two unaffiliated companies would charge each other.
"If the IRS were to pursue the matter, it will prevail in court on the issue of whether Vanguard should have charged its affiliated funds an arm's length advisory fee based on industry comparables," wrote Avi-Yonah.
Prior TaxProf Blog coverage:
- Former Vanguard Tax Lawyer Files Whistleblower Suit Alleging Mutual Fund Giant Became Low-Cost Leader by Evading $1 Billion in Taxes (July 26, 2014)
- Experts Assess Whistleblower's Lawsuit Challenging Vanguard's Tax Structure (July 30, 2014)
- Who Is the Vanguard Tax Whistleblower? (Aug. 25, 2014)
- Vanguard Seeks to Dismiss Whistleblower Suit by its Former Tax Lawyer (Oct. 27, 2014)
- Tax Whistleblower Claims Vanguard Tried to Silence Him (Dec. 1, 2014)
- Vanguard Tax Whistleblower's First Day in Court (Feb. 21, 2015)
- IRS Review of Vanguard's Tax Structure at Heart of Whistleblower's $1 Billion Tax Claim (Feb. 23, 2015)
- Avi-Yonah: Vanguard Owes $35 Billion In Back Taxes (Sept. 24, 2015)
- Avi-Yonah: Too Big to Tax? Will The IRS Enforce The Arm's Length Standard Against Vanguard? (Oct. 6, 2015)
- NY Court: Ethics Rules Bar Whistleblower Suit By Former Vanguard Tax Lawyer Alleging Mutual Fund Giant Evaded $1 Billion in Taxes (Nov. 19, 2015)
- Johnston: Vanguard Investor Fees Could Quadruple If Tax Whistleblower Prevails (Dec. 4, 2015)