Vanguard is the world’s largest complex of mutual funds, with over $3 trillion in assets under management, including $215 billion added in 2014. Vanguard’s main attraction to investors is its low costs. Profs. Freeman and Brown (2000) report that the advisory fees charged by the Vanguard Group “tend to present lower expense ratios than the rest of the mutual fund industry” because “Vanguard funds are run on the same basis as most companies in the economy: boards are unswervingly devoted to making as much money as possible … for shareholders [of the funds]. Stated differently, Vanguard funds are uncontaminated by the conflict of interest that affects most of the rest of the fund industry.” Michael Rawson, a Morningstar analyst, told the Financial Times in May 2015 that “[i]t is phenomenal that a single company could represent almost 20 percent of the US mutual fund industry. But they have done it through offering products that are consistently lower cost than other funds”.

The main reason for Vanguard’s lower fees than, for example, the fees charged by Fidelity (its closest rival) is that Vanguard has a unique structure, approved by the SEC in 1975: The investment manager (Vanguard Group Inc., or VGI) is owned by the Vanguard domestic mutual funds (the Funds) in proportion to Net Asset Value. This structure, Profs. Freeman and Brown argue, means that there is no conflict of interest between VGI and the Funds, while every other mutual fund complex has the advisor charging too much because it puts the interest of shareholders of the advisor ahead of investors that are shareholders of the funds.

Profs. Coates and Hubbard (2007) have argued that this situation should result in investors moving from other funds to Vanguard, and the recent phenomenal growth of Vanguard suggests that they were right. But there is a problem: As David Danon, a former Vanguard in-house tax lawyer, has argued in a lawsuit filed in 2013, the Vanguard structure directly contravenes the arm’s length standard of Treas. Reg. 1.482-1(b)(1) because VGI provides services to the Funds “at cost”, i.e., without charging an arm’s length profit.

VGI and its domestic subsidiaries are taxable corporations under Subchapter C of the Code. The Funds are RICs and therefore are not taxable at the Fund level if they meet the requirements of Subchapter M of the Code, including distributing 90% of their income to Fund investors annually. VGI is wholly-owned by the US Funds in proportion to their NAV. The Vanguard Board of Directors is identical to the Trustees of the Funds.

The Treasury regulations state that “[t]he purpose of section 482 is to ensure that taxpayers clearly reflect income attributable to controlled transactions and to prevent the avoidance of taxes with respect to such transactions. Section 482 places a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining the true taxable income of the controlled taxpayer.” The Vanguard Group is a “controlled” taxpayer in relation to the Funds because the Funds own VGI (which in turn owns the other corporations in the Vanguard Group).

The Treasury regulations go on to state that “[i]n determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer. A controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm’s length result).”

Treas. Reg. 1.482-9 provides methods to determine taxable income in connection with a controlled services transaction (a transaction involving the provision of services between controlled taxpayers). Treas. Reg. 1.482-9(a) requires controlled taxpayers to charge an arm’s length price for services provided to other controlled taxpayers. Under Treas. Reg. 1.482-9(b), controlled taxpayers must provide services at a profit unless they meet the requirements of the “services cost method”, which permits them to provide certain narrowly defined services “at cost” without a markup.

Under Treas. Reg. 1.482-9(b)(2), in order for the services cost method to apply, all the requirements of that section must be met, including that it is not precluded from being a covered service under the business judgment rule of Treas. Reg. 1.482-9(b)(5).

Under Treas. Reg. 1.482-9(b)(5), “[a] service cannot constitute a covered service unless the taxpayer reasonably concludes in its business judgment that the service does not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in one or more trades or businesses of the controlled group, as defined in § 1.482-1(i)(6). In evaluating the reasonableness of the conclusion required by this paragraph (b)(5), consideration will be given to all the facts and circumstances.” Vanguard’s own promotional materials emphasize that the “at cost” pricing of the services provided by the Vanguard Group to the Funds is the “key competitive advantage” of the Funds in attracting and retaining investors. Moreover, it is clear that the investment advisory services provided by VGI to the Funds are the “core capability” of VGI.

Once it is established that the services provided by the Vanguard Group to the Funds are not eligible for the services cost method, the next task is to establish an appropriate mark-up. Morningstar publishes summaries of expense ratio trends. Based on their data, the average expense ratio for Vanguard (if it included a profit component like other mutual fund complexes) should be between 0.71-0.82% of NAV, rather than around 0.2% of NAV as reported by Vanguard. Based on this data the report I submitted to the IRS on September 21, 2015, concluded that Vanguard owes $34.6 billion for 2007-2014.

Under current law, the IRS has the legal ammunition it needs to tax Vanguard on billions of dollars in annual income. So the question remains: Will the IRS be willing to take on many millions of investors? Or is Vanguard too big to tax? Since the IRS (so far) has not publicly acted, this question remains open at present. But there is a good chance that the IRS will determine that Vanguard is liable for tens of billions in taxes, and that its fees will have to be raised to cover this liability, erasing some (but not all) of its competitive advantage over its rivals.

The preceding post comes to us from Reuven S. Avi-Yonah, the Irwin I. Cohn Professor of Law and Director, International Tax LLM Program at the University of Michigan Law School. The post is based on his recent article, “Too Big to Tax? Vanguard and the Arm’s Length Standard”, which is available here.