(Bloomberg) -- Near the end of January, 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.
Lowering fees for customers. Outrageous!
That, in short, is the argument Vanguard tax lawyer-turned whistleblower 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. But the argument's underlying reasoning is simple: Vanguard is cheating state and federal tax authorities by charging its customers much less than other fund companies do.
Vanguard has $3.2 trillion in U.S. fund assets under management, and its asset-weighted average expense ratio is 0.14%, compared with an industry average of 0.64% . 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 IRS $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.
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 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.
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. Transactions between the funds and the management companies may thus be subject to transfer-pricing rules designed to keep corporations from shifting profits from high-tax jurisdictions to low-tax ones. That's not what Vanguard is doing, of course, but Danon and Avi-Yonah argue that it is still required to charge "arm's-length" fees similar to what other management companies charge.
At almost every mutual-fund group other than Vanguard, the management company is out to make a profit, so charging too-low fees isn't really an issue. But at Vanguard, the funds - and by extension the investors in the funds - own the management company, and expect it to keep fees as low as possible. Why the difference? A little history is in order, in part because it shows that Vanguard isn't so much a weird outlier as a worthy carrier of the mutual-fund tradition.
The original mutual fund was the Massachusetts Investors Trust, founded in Boston in 1924. MIT, as it was known, was a customer-owned non-profit -hence the name mutual fund. The fund trustees made the investment decisions and charged extremely low fees. MIT weathered the 1929 market crash and the bear market of the early 1930s better than most of its profit-seeking rivals, and came to dominate the nascent mutual-fund industry. When Congress created the Investment Company Act of 1940, MIT ensured that the mutual structure and its customer-first aims were preserved.
Still, most other fund groups paired mutual funds with for-profit management companies. In 1969 MIT and a sister fund joined the crowd by demutualizing and starting a for-profit management firm called Massachusetts Financial Services. It came back six years later as the result of a power struggle at another venerable mutual fund group, Philadelphia-based Wellington.
Wellington Management had merged in the 1960s with a fast-growing Boston fund manager. Things turned sour during the bear market of 1973 and 1974, and the Boston partners voted to oust Wellington's president. This fellow - Jack Bogle - still had a lot of loyal allies on the boards of Wellington's mutual funds, so he arranged a coup, with the funds taking charge of their own destiny as the Vanguard Group. They still paid Wellington to manage the money in the Wellington and Windsor funds (and they still do), but Bogle soon came up with an alternative, the first unmanaged index fund for individual investors.
Vanguard has revolutionized the money management business, putting pressure on competitors to lower fees. Those lower fees have in turn made it easier for millions of Americans to save for retirement and other goals. It's a virtuous cycle that has both changed investing for the better and brought the mutual fund industry back closer to its roots. If the IRS or the courts decide to go after Vanguard for its frugality, it would amount to throwing all this into reverse.
One possible countervailing public policy argument is that the owners of Vanguard funds are more affluent than Americans in general, so by forcing Vanguard to charge higher fees and then taxing the resulting profits, the IRS and the states would be fighting income inequality.