Assistant Professor Daniel Hemel on the Vanguard Group’s potential tax liabilities:
CBS News posted a story on its website last week headlined, “Vanguard investors, your fund fees could quadruple.” The report follows a Newsweek article earlier this month asserting that Vanguard may have to quadruple its average fee in response to claims that the mutual fund company has been avoiding taxes. The University of Chicago, like nearly 2,000 other employers, offers retirement plans to its employees through Vanguard, so the subject is of more than academic interest here. Could it really be that Vanguard will have to quadruple its expense ratio in order to cover its tax liabilities?
In a word: No. 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.
First, a bit of background on Vanguard’s structure: Vanguard Group, Inc. (VGI) is a corporation headquartered in Pennsylvania and chartered in Delaware that provides investment management and administrative services to various Vanguard mutual funds. VGI is a C corporation for federal tax purposes; the mutual funds are regulated investment companies, or “RICs.” VGI must pay corporate income tax just like any other C corporation; the mutual funds generally are not taxed as long as they distribute at least 90% of their income to investors. The mutual funds technically own VGI—an arrangement described in more detail by John Morley in this excellent Yale Law Journal article.
The Vanguard mutual funds pay VGI for the services that VGI provides. As Reuven Avi-Yonah explains in a recent Tax Notes article, VGI is a “controlled” taxpayer in relation to the mutual funds for purposes of the transfer pricing rules because the mutual funds own VGI. Transfer pricing rules require VGI to report income based on the price that it would have received from each mutual fund in an “arm’s length” transaction. So if a Vanguard mutual fund pays VGI $5 for services that would have been priced at $10 in an arm’s length transaction, VGI must pay taxes as if it had received $10 from the mutual fund, even though it actually received only $5.
VGI charges the mutual funds “at cost,” without any markup. The problem with this approach from a tax perspective is that service providers generally don’t price their services at cost; they try to earn a profit. According to former Vanguard tax attorney-turned-whistleblower David Danon, VGI is underreporting its taxable income because it doesn’t account for the markup it would receive if it dealt with the mutual funds at arm’s length. Vanguard has an obvious incentive to report lower income for VGI and (correspondingly) higher income for the mutual funds because VGI is taxable at a 35% corporate rate while the mutual funds generally pay no tax. (Investors in the mutual funds may be liable for tax, but many of Vanguard’s customers hold their mutual fund shares through IRAs, 401(k) plans, and other vehicles that are effectively tax-exempt.)
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.
Fortunately, Morningstar’s data allows us to make apples-to-apples comparisons. Vanguard’s most popular products are its large cap blend index funds, including its Total Stock Market Index Fund and the S&P-tracking Vanguard 500 Index Fund. In 2013, the average asset-weighted expense ratio for Vanguard’s large blend index funds was 13 basis points below the asset-weighted average for non-Vanguard large blend index funds. In some other sectors, the cost difference was wider (48 basis points for large growth index funds); in still other sectors the gap was narrower (8 basis points for foreign large blend index funds, 12 basis points for intermediate bond index funds). Note that after the large blend category, assets in index funds are concentrated in the foreign large blend and intermediate bond categories—the segments for which the cost difference between Vanguard and non-Vanguard funds is the smallest. And the cost difference is even narrower for some categories of exchange-traded funds (e.g., 4 basis points for large blend ETFs).
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. This comparison is admittedly suboptimal: ideally one would run the comparison across all fund categories with appropriate adjustments for asset weights. But the available Morningstar data isn’t detailed enough to allow for the ideal comparison. And using the gap between expense ratios for Vanguard and non-Vanguard large blend index funds strikes me as quite a bit better than an apples-to-oranges comparison between Vanguard funds and the industry-wide (actively managed plus index) average. (One of the many admirable aspects of Avi-Yonah’s expert report is that he is crystal clear about his assumptions, making it easy for others to reconstruct his calculations while tweaking those assumptions.)
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.
I acknowledge that this estimate is quite rough (and I look forward to hearing suggestions as to how it might be made more precise). I think it’s at least in the right ballpark though. Note that $9.9 billion is equal to about 0.32% of Vanguard’s assets under management (i.e., 32 basis points). If Vanguard spreads that cost across all of its funds, investors would face a significant one-time charge—but 32 basis points on top of an existing average expense ratio of 18 basis points is not a “quadrupling” by any measure.
So far, I’ve only addressed Vanguard’s potential liability for back taxes. What about for future years? Even if VGI has to add 13 basis points to the price it charges the mutual funds for tax purposes, that doesn’t mean VGI actually has to collect an additional 13 basis points from the funds. Rather, it has to calculate taxable income as if it were charging the arm’s length rate. The federal corporate income tax rate tops out at 35%; the top tax rate on corporate net income in Pennsylvania is 9.99%; and when one factors in the federal deduction for state income taxes, Vanguard’s rate comes out to 41.5%. (This is an overestimate because some of Vanguard’s income would be apportioned to Arizona and North Carolina, where corporate tax rates are lower than in Pennsylvania.) Multiply 41.5% by 13 basis points and you get roughly 5.4 basis points—which is to say, Vanguard funds would have to pay an extra 5 or so basis points to VGI in order to compensate VGI for its additional federal and state corporate income tax liabilities.
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.