Paul L. Caron

Friday, December 4, 2015

Johnston: Vanguard Investor Fees Could Quadruple If Tax Whistleblower Prevails

VanguardNewsweek:  Vanguard Whistleblower Could Get Billions in Tax Dodge Complaint, by David Cay Johnston (Syracuse):

If you are among the 20 million Americans saving for retirement through Vanguard, you may be in for an expensive shock. The nation’s second-largest mutual fund company (after Fidelity) is under fire for not taking more of your money. That sounds ridiculous, but based on arcane provisions of the endlessly complex U.S. tax code, the Pennsylvania-based company may soon be forced to pay a staggering amount of back taxes because of the famously low fees it charges to manage your nest egg.

Two years ago, David Danon, a former Vanguard tax lawyer who is now a whistleblower no one would ever confuse with Erin Brockovich, filed formal complaints with the Internal Revenue Service and many state taxing agencies claiming that Vanguard’s low fees are an illegal tax dodge. He argues that Vanguard should have charged investors an extra $19.8 billion in investment fees this year alone and owes almost $35 billion in taxes, interest and penalties since 2007. Under a 2006 law, a tax whistleblower may collect 15 to 30 percent of what the IRS collects, which means Danon could be heading for a payday of up to $10 billion. ...

If Danon wins in other courts—and tax law seems to be on his side—people investing through Vanguard would accumulate much less money in their accounts because higher fees would cut into their investment gains. One of the most widely read tax scholars in America, professor Reuven Avi-Yonah of the University of Michigan Law School, says the case against Vanguard is clear-cut. “The IRS will win in court if it challenges Vanguard’s” policy of not earning profits, he tells Newsweek.

There is a double whammy here for Vanguard’s customers: Raising fees to cover those taxes could require quadrupling its average fee, according to Avi-Yonah, who is working with Danon on this issue. Increasing Vanguard’s average annual fee of $2 per $1,000 invested to the industry average would mean a fee of $8.20. If the stock market goes up by 5 percent, or $50 for every $1,000 invested with Vanguard, the amount investors keep after fees would drop from $48 to less than $42. Over time, that smaller return takes a larger and larger bite from investors because there is less money to reinvest. ...

Congress could resolve Danon’s complaint in several ways and allow Vanguard to stick with its low fees. One would be to add a line to Section 482 explicitly exempting from tax any mutual fund investment management company owned by the mutual funds it serves. That would surely set off a huge lobbying blitz by other mutual funds, which would surely like to see Vanguard forced to raise its fees and diminish its huge competitive advantage.

Another solution would be to add a 30th exemption to the list of nonprofit activities allowed in the tax code.

If Congress bails out Vanguard with either of those moves, it could add a requirement that Vanguard disclose how much it pays its executives and money managers, perhaps all those making $1 million or more.

Prior TaxProf Blog posts:

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I still don't get it. The very premise of Vanguard is to increase investor returns by lowering costs. So how is this cheating, again?

Posted by: Dale Spradling | Dec 14, 2015 6:55:00 AM

@DCJ -- But you should have at least mentioned the decision. Describe as "bizarre" if you want, but you omitted a material fact. Also worth mentioning that if NYS declines to participate in the suit, the qui tam plaintiff must obtain permission from the NY AG before making any motion to compel Dept of Taxation participation. §189.4(b) of NY FCA.

Posted by: Tu Phat | Dec 14, 2015 6:34:46 AM

David Jay, Danon is appealing the NY trial court decision, which is bizarre and has zero effect on whether Vanguard owes NYState axes, only on his eligibility to collect a reward. The dismissal says he cannot collect because he was an insider who was involved. Every whistleblower I have dealt with over the decades was on the inside and involved -- that is the very definition of whistleblowing.

Posted by: David Cay Johnston | Dec 14, 2015 4:20:45 AM

I am amazed that David Cay Johnson would write this article on December 3 and not even mention that Danon's primary suit (filed in NY) was dismissed with prejudice. He is still writing ("if Danon prevails in court") as if the suit is still ongoing.

Posted by: David Jay | Dec 6, 2015 6:24:46 PM

ps--Vanguard is getting a good deal if Prof. Avi-Yonah is charging only $850/hour. He's one of the very best tax law professors in the world, and so far this sounds like a small job--- consisting of, say, 12 hours of work to come up with these preliminary estimates, though I'm no expert on being an expert. The big money would come later, if this got near trial, and it probably won't.

Posted by: Eric Rasmusen | Dec 6, 2015 3:23:34 PM

Professor Avi-Yonah and Mr. Johnston are both right. According to Professor Avi-Yonah's analysis, the advisory fee will quadruple (as Johnston says). Since the mutual funds own the advisory corporation, however, only the third or so of that quadrupling which is paid out as corporate income tax would be lost to mutual fund investors (as Avi-Yonah says). That's true whether or not the rest of the advisory corporation profit is rebated as Avi-Yonah suggests in his comment. If it isn't rebated, the mutual funds still get it as capital gains; they ultimately own all the profits of the advisory corporation.

I do think that Professor Avi-Jonah's analysis is wrong, though. He is saying that Vanguard needs to charge the same percentage as other fund advisor corporations. MG notes that a first adjustment is that the comparison corporations have to be mostly index funds. More importantly, for this purpose what we want to know is not what profit Vanguard *could* make from its mutual fund clients, who are captive customers, but what it is its cost of capital. Thus, we would need to know its amount of capital and the risk-adjusted market rate of return. The risk is very low, since Vanguard has captive customers who will not "fire" it if it is unlucky in its advisory services. Thus, even if Danon were to win, the amount of corporate income tax to be paid would be relatively low.

Posted by: Eric Rasmusen | Dec 6, 2015 3:12:47 PM

MG: your son's suit would have two problems. First, you need to underpay your tax by at least $125,000, if I remember the minimum correctly, which I might not. Second, you and your wife are not filing as a corporation and a subsidiary.

Posted by: Eric Rasmusen | Dec 6, 2015 2:59:37 PM

Vanguard manages mostly index funds. Others in the industry offer similar products at similar (low) fees. This is not (mostly) marketing or strategy. It is the result of not spending a lot of money chasing results. Even if the whistle blower and the Prof. are right about the law, the transfer pricing arbitrage here ought to be small (or definitely smaller than fees could quadruple).

But as an issue of administrative over reach (or if nor over reach, pointless reach), this is troubling. Can my son get whistle blower fees if he turns my family in ti the IRS for non-reporting the value of all the work I do for my wife and she does for me around the house?

Posted by: MG | Dec 6, 2015 12:49:17 PM

Vanguard "could" also raise its fees now (before any IRS action) to be the same as its competitors. But it will not because its whole selling point is its lower fees. If it is taxed it will probably have to raise its fees to cover the tax over time, but I don't see why it would raise them further since its whole selling point is that it is not about profit.
So I still think that the statement that Vanguard may quadruple its fees if it is taxed is wrong and misleading.

Posted by: Reuven Avi-Yonah | Dec 6, 2015 9:55:05 AM

Reuven, referring to my Newsweek article that characterized his analysis as compelling, writes, “It is not accurate to say that imposing tax could cause Vanguard to quadruple its fees.” In his expert report to the IRS and SEC Reuven wrote:
“The IRS should be able to defend in court a determination that the arm’s length fee charged by Vanguard to its affiliated funds for the tax years 2007-2014 should have been on average in the range of 0.71% and 0.82% of each fund’s net asset value.”
Reuven cites actual fees of 0.20%, a figure that when quadrupled falls within his range. I carefully chose a conditional verb, writing that fees “could” quadruple.
Vanguard Group, the C corporation investment manager, could choose to rebate some or all of the after-tax profits to the affiliated funds. Note the conditional verb.

Posted by: David Cay Johnston | Dec 6, 2015 3:24:30 AM

L'C: Prof. Avi-Yonah was open about his rate ($850/hour) in this article I wrote about his report in the Philadelphia Inquirer in September:

Posted by: Joseph N DiStefano | Dec 5, 2015 2:01:53 PM

Reuven, how much money are you getting???

Posted by: L'C | Dec 4, 2015 11:33:55 AM

It is not accurate to say that imposing tax could cause Vanguard to quadruple its fees. The industry average includes both tax and after tax profit and even if it paid the former Vanguard would be free to rebate the latter to its investors. The likely rise in fees is therefore much lower than suggested in the article, and I never said anything like what is attributed to me.

Posted by: Reuven Avi-Yonah | Dec 4, 2015 7:10:59 AM

Proving that government-advocated consumer protection is a fraud. If if comes to businesses charging customers lowers fees, or the government collecting more taxes on imputed income, they'll go for more tax money every time.

Posted by: ruralcounsel | Dec 4, 2015 5:58:27 AM