Paul L. Caron

Monday, December 28, 2015

Hemel:  Taxes To Cause Vanguard Fund Fees To 'Quadruple'? Not So Fast.

VanguardFollowing up on last week's post, CBS News: Vanguard Investors, Your Fund Fees Could Quadruple If Michigan Tax Prof Reuven Avi-Yonah Is Right:  University of Chicago Law Faculty Blog:  Vanguard Fund Fees To "Quadruple"? (Not So Fast), by Daniel Hemel:

There is no plausible scenario in which tax law would require Vanguard to quadruple its fees. If the IRS chooses to enforce transfer pricing rules against Vanguard, the mutual fund company may have to increase its fees modestly—but nowhere close to the “quadrupling” suggested by media reports. ...

Professor Avi-Yonah expands on this argument in his article and in an expert report submitted to the IRS and SEC in connection with Danon’s whistleblower submission. Avi-Yonah’s basic logic strikes me as sound. VGI should be reporting income as if it were receiving arm’s length prices from Vanguard mutual funds. If it’s not, then VGI is underpaying the IRS and state tax authorities.

The harder question is: by how much is Vanguard underreporting its taxable income?

Professor Avi-Yonah pegs the arm’s length price of VGI’s services at 71 to 82 basis points (0.71% to 0.82%), a figure based on average expense ratios for all mutual funds from 2007 through 2014 as reported by Morningstar. Avi-Yonah compares this to Vanguard’s average expense ratio of 18 to 21 basis points over the same period. Avi-Yonah notes that “average fees reported by Morningstar understate the true arm’s-length price because the average includes Vanguard’s non-market fees.”

Significantly, though, Morningstar’s industry-wide average includes actively managed funds as well as index funds, while assets under management at Vanguard are predominantly in index funds. Active management and index fund management are very different services that command very different prices in arm’s length transactions. So comparing Vanguard (predominantly index funds) to the industry-wide average (actively managed and index funds) is like comparing apples to oranges—or, perhaps more precisely, comparing a basket of apples to a basket that includes both apples and oranges. The apples-to-apples comparison would be Vanguard index funds versus non-Vanguard index funds. ...

To get a better sense of just how much Vanguard might owe in back taxes, I reconstructed Avi-Yonah’s calculations, but instead of using the difference between Vanguard’s average expense ratio and the industry-wide average for actively managed funds and index funds, I relied on an apples-to-apples comparison between the average expense ratios for Vanguard large blend index funds and non-Vanguard large blend index funds. ...

Morningstar’s data on expense ratios for Vanguard and non-Vanguard large blend index funds goes through 2013; lacking 2014 data, I assumed that the 13 basis point differential in 2013 remained constant over the next year. On those assumptions, Vanguard’s estimated underreported income for 2007 through 2014 is $18.6 billion, compared to Avi-Yonah’s estimate of $70.6 billion. Factoring in a 40% penalty plus interest (as Avi-Yonah does), the sum total for taxes and penalties due to the IRS comes to $9.9 billion—well below Avi-Yonah’s estimate of $34.6 billion. ...

The bottom line is that if the IRS enforces transfer pricing rules against Vanguard, investors might face a one-time charge of roughly 30 basis points and a recurring charge of roughly 5 basis points per year, on top of average fees today of approximately 18 basis points across Vanguard funds. These amounts aren’t insignificant; an individual who opens an IRA with Vanguard and holds it for several decades may see the ultimate value of the funds in her account reduced by more than a full percentage point as a result. Even so, you’re still a lot better off over the long term in the Vanguard 500 than, say, a JPMorgan index fund tracking the S&P 500 with an expense ratio of 45 basis points.

All of this assumes that the IRS chooses to go after Vanguard on transfer pricing. And it very well might not. For an agency already under fire, pursuing a transfer pricing case against a popular mutual fund company does not seem like a politically savvy move—especially when that mutual fund company manages the retirement savings of millions of Americans. This is not to say that the IRS shouldn’t go after Vanguard, but I’d be surprised if it did. Professor Avi-Yonah asks whether Vanguard is “too big to tax”; perhaps the question is whether it’s too beloved.

Prior TaxProf Blog coverage:

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ubit, I've thought about the same thing. I think in the past Vanguard thought its current scheme was fine, taxwise, so there was no need for even a slight inconvenience of reorganization. This also suggests VG would win the New York Danon lawsuit even if Danon's appeal wins, because the New York FCA requires scienter and VG clearly didn't think its scheme was evading taxes.

Posted by: Eric Rasmusen | Dec 28, 2015 5:53:35 PM

jpe - is the above cost element UBIT to the funds? Is there some de-minimis rule? Would each fund need to own its own management company to avoid being deemed to provide service to each other?

Posted by: lv | Dec 28, 2015 8:37:50 AM

Why couldn't the management company simply convert to an LLC taxable as a partnership? The management company isn't itself public, so it wouldn't *need* to be a C corp as far as I know. Any above-cost fees could simply be distributed back to the funds.

Posted by: jpe | Dec 28, 2015 6:57:12 AM