Can the IRS
go after you for not making enough profit?
There is a whistleblower
case against Vanguard, the mutual fund giant. Even though there is a tax angle,
I had previously sidestepped the matter. Surely it must involve some
mind-numbing arcana, and –anyway- why enable some ex-employee with a
grudge?
And then I
saw a well-known University of Michigan tax professor supporting the tax issues
in the whistleblower case.
Now I had to
look into the matter.
My first reaction is that this case represents tax law gone wild. It happens. Sometimes tax law is like the person looking down at his/her cell phone and running into you in the hall. They are too self-absorbed to look up and get a clue.
What sets
this up is the management company: Vanguard Group, Inc. (VGI). Take a look at
other mutual fund companies and you will see that the management company is
separately and independently owned from the mutual funds themselves. The management company provides investment,
financial and other services, and in turn it receives fees from the mutual
funds.
The
management company receives fees irrespective of whether the funds are doing
well or poorly. In addition, the ownership of the management company is likely different
from the ownership of the funds. You can invest in the management company for
T. Rowe Price (TROW), for example, even if you do not own any T. Rowe Price
funds.
Vanguard
however has a unique structure. Its management company – VGI – is owned by the
funds themselves. Why? It goes back to Jack Bogle and the founding of Vanguard:
he believed there was an inherent conflict of interest when a mutual fund is
advised by a manager not motivated by the same financial interests as fund
shareholders. Since the management
company and the funds are essentially one-and-the-same, there is little
motivation for the management company to maximize its fees. This in turn has
allowed Vanguard funds to provide some of the lowest internal costs in the
industry
My first
thought is that every mutual fund family should be run this way.
VGI and all
the funds are C corporations under the tax Code. The funds themselves are more
specialized and are “registered investment companies” under Subchapter M.
Because the funds own VGI, the “transfer pricing” rules of IRC Section 482
apply.
COMMENT: The intent of Section 482 is to limit the ability of
related companies to manipulate the prices they charge each other. Generally
speaking, this Code section has not been an issue for practitioners like me, as
we primarily serve entrepreneurs and their closely-held companies. This market
tends to be heavily domestic and unlikely to include software development, patent
or other activity which can easily be moved overseas and trigger transfer
pricing concerns.
Practitioners are however starting to see states pursue
transfer pricing issues. Take Iowa, with its 12% corporate tax rate as an
example. Let’s presume a multistate client with significant Iowa operations. Be
assured that I would be looking to move profitability from Iowa to a lower
taxed state. From Iowa’s perspective, this would be a transfer pricing issue. From
my perspective it is common sense.
Section
482 wants to be sure that related entities are charging arm’s-length prices to
each other. There are selected exceptions for less-than-arm’s-length prices,
such as for providing routine, ministerial and administrative services. I
suppose one could argue that the maintenance and preparation of investor
statements might fit under this exception, but it is doubtful that the provision
of investment advisory services would.
Those services involve highly skilled money managers, and are arguably
far from routine and ministerial.
So VGI must arguably
show a profit, at least for its advisory services. How much profit?
Now starts
the nerds running into you in the hall while looking down at their cell phones.
We have to
look at what other fund families are doing: Janus, Fidelity, Eaton Vance and so
on. We know that Vanguard is unique, so we can anticipate that their management
fees are going to be higher, potentially much higher. An analysis of
Morningstar data indicates as much as 0.5 percent higher. It doesn’t sound like
much, until you consider that Vanguard has approximately $3 trillion under
management. Multiply any non-zero number by $3 trillion and you are talking
real money.
It is an
interesting argument, although it also appears that the IRS was not considering
Vanguard’s fact pattern when it issued Regulations. Vanguard has been doing
this for 40 years and the IRS has not concerned itself, so one could presume
that there is a détente of sorts. Perhaps the IRS realized how absurd it would
be to force the management company to charge more to millions of Vanguard
investors.
That might
attract the attention of Congress, for example, which already is not the
biggest fan of the IRS as currently administrated.
Not to
mention that since the IRS issued the Regulations, the IRS can change the
Regulations.
And all that
presumes that we are correctly interpreting an arcane area of tax law.
The
whistleblower is a previous tax attorney with Vanguard, and he argues that
Vanguard has been underpaying its income taxes by not charging its fund
investors enough.
Think about
that for a moment. Who is the winner in this Alice-in-Wonderland scenario?
The whistleblower says that he brought his concerns to the attention of his superiors (presumably tax attorneys themselves), arguing that the tax structure was illegal. They disagreed with him. He persisted until he was fired.
He did however
attract the attention of the SEC, IRS and state of New York.
I had
previously dismissed the whistleblower argument as a fevered interpretation of
the transfer pricing rules and the tantrum of an ex-employee bent on
retribution. I must now reevaluate after
tax law Professor Reuven S. Avi-Yonah has argued in favor of this case.
I am
however reminded of my own experience. There is a trust tax provision that entered the
Code in 1986. In the aughts I had a client with that tax issue. The IRS had not
issued Regulations, 20 years later. The IRS had informally disclosed its
internal position, however, and it was (of course) contrary to what my client
wanted. I in turn disagreed with the IRS and believed they would lose if the
position were litigated. I advised the client that taking the position was a
concurrent decision to litigate and should be addressed as such.
I became extremely
unpopular with the client. Even my partner was stressed to defend me. I was
basing professional tax advice on chewing gum and candy wrappers, as there was
nothing else to go on.
And eventually
someone litigated the issue. The case was decided in 2014, twenty eight years
after the law was passed. The taxpayer won.
Who is to
say that Vanguard’s situation isn’t similar?
What does this tax guy think?
I preface by
saying that I respect Professor Avi-Yonah, but I am having a very difficult
time accepting the whistleblower argument. Vanguard investors own the Vanguard
funds, and the funds in turn own the management company. I may not teach law at
the University of Michigan, but I can extrapolate that Vanguard investors own
the management company – albeit indirectly – and should be able to charge
themselves whatever they want, subject to customary business-purpose principles. Since tax avoidance is not a principal purpose, Section 482 should not be sticking its nose under the tent.
Do you wonder
why the IRS would even care? Any income not reported by the management company
would be reported by fund investors. The Treasury gets its pound of flesh - except
to the extent that the funds belong to retirement plans. Retirement plans do
not pay taxes. On the other hand, retirement plan beneficiaries pay taxes when
the plan finally distributes. Treasury
is not out any money; it just has to wait. Oh well.
It speaks volumes
that someone can parse through the tax Code and arrive at a different
conclusion. If fault exists, it lies with the tax Code, not with Vanguard.
Then why
bring a whistleblower case? The IRS will pay a whistleblower up to 30% of any
recovery, and there are analyses that the Vanguard management company could be on the hook
for approximately $30 billion in taxes. Color me cynical, but I suspect that is
the real reason.
