Near the end of last month, mutual-fund giant Vanguard announced that it had lowered the expense ratios on 35 of its mutual funds. That’s after a December announcement that it had lowered expense ratios on 53 funds. All in all, Vanguard estimated, the changes resulted in an $87.4 million reduction in the fees paid by its customers.
Isn’t that outrageous!?!?! I mean, seriously, how shameless can these guys get?
That, in short, is the argument Vanguard tax lawyer turned whistle-blower David Danon and his hired expert, University of Michigan law professor Reuven S. Avi-Yonah, are making.
Yes, there's a more complicated legal angle involving transfer pricing. More on that in a bit. But the underlying reasoning is simple: Vanguard is cheating state and federal tax authorities by charging its customers much less than other fund companies do. Which is exactly as bonkers as it sounds. (This seems like it might be a good spot to disclose that while I don’t own any Vanguard funds, my wife does.)
Vanguard has $3.2 trillion in U.S. fund assets under management, and its asset-weighted average expense ratio is 0.14 percent, compared with an industry average of 0.64 percent. That means Vanguard’s fees bring in about $4.5 billion a year, and if they were raised to the industry average they would bring in about $20.5 billion. Since Vanguard is run at break-even now, that difference would presumably be profit, and thus subject to corporate income taxes.
Using similar calculations, Avi-Yonah contends that Vanguard owes the Internal Revenue Service $34.6 billion in back taxes for the years 2007 through 2014. And Newsweek estimates that Danon, as the whistle-blower, could pocket as much as $10 billion of that.
Remember, these would be taxes on profits that were never earned, from fees that were never collected. Vanguard clearly wasn’t engaging in any subterfuge. The whole thing was out in the open.
My Bloomberg View colleague Matt Levine has dubbed this “the faked moon landing of financial news stories, except that it might be true." Danon collected a $117,000 whistle-blower bounty in Texas in November, meaning that Vanguard paid the state at least $2.3 million.
It’s possible that Vanguard’s payment had nothing to do with the fee issue -- a company spokesman told Bloomberg’s Jesse Drucker that Danon’s arguments didn’t come up in the company’s discussions with state tax authorities. But Danon did collect a fee, and Avi-Yonah really is an expert on transfer pricing. Their claims can’t be completely dismissed.
Jeff Sommer described the legal niceties in detail in a New York Times column last weekend, which included quotes from two law professors who don’t buy Danon and Avi-Yonah’s reasoning. But the basic argument is this: Mutual-fund organizations are made up of two kinds of entities -- mutual funds that are owned by their customers and exempt from income taxes, and corporations that manage the mutual funds’ assets and charge fees for that service.