The Legal community has spoken: Vanguard’s structure is illegal and vanguard Is Likely Insolvent

 

Introduction

I am not a lawyer, let alone a tax lawyer, so I haven’t really understood the seriousness of Vanguard’s federal income tax liability until now. But after consultation with three lawyers with law degrees from top law schools and decades of experience at top national law firms I now understand it. These lawyers have worked extensively with me to write this very special post.

These three lawyers have told me that:

  • It is completely clear that Vanguard’s “at cost” structure is illegal.
  • It is virtually certain that the IRS has (1) audited Vanguard, (2) notified Vanguard that its “at-cost” services are illegal, and (3) assessed (or will soon assess) liability for back taxes of billions of dollars.
  • It is very likely that Vanguard is insolvent because its tax liability exceeds its assets.

Let me state this clearly: all U.S. tax lawyers with knowledge of transfer pricing tax law agree that Vanguard’s structure is illegal. This is not a question on which there is debate among the experts; they all agree with David Danon, the whistleblower who reported Vanguard’s violations to the IRS.

AND I HAVE A CHALLENGE TO YOU, VANGUARD – – I KNOW YOU READ MY BLOG:

  • PROVIDE TO THE WORLD THE NAME OF A SINGLE TAX LAYWER AT A NATIONALLY RECOGNIZED LAW FIRM WHO WILL DEFEND YOUR POSITION.
  • PROVIDE TO THE WORLD A SINGLE LEGAL DEFENSE TO THE U.S. INCOME TAX REGULATIONS DISCUSSED BELOW THAT, AS EVERY TRANSFER PRICING TAX LAWYER HAS STATED, APPLIES TO YOUR STRUCTURE.
  • EXPLAIN TO THE WORLD WHAT YOU MEANT WHEN YOU ADMITTED IN DANON’S NEW YORK CASE THAT THE SECTION 482 RULES APPLY TO YOUR STRUCTURE.
  • IF I’M WRONG ABOUT THIS, WHY CAN’T YOU TELL THE WORLD THAT THE IRS HAS APPROVED YOUR STRUCTURE?
  • IF YOU’RE NOT BEING AUDITED, WHY CAN’T YOU SAY THAT?

My lawyer friends and I think it will be better to write two posts. This post will lay out the legal landscape: that Vanguard has not a shred of legal support for its position, how Vanguard got away with violating clear law for so long, and the magnitude of Vanguard’s tax liability. A follow-up post will describe the income tax rules Vanguard has violated, but a few words on that here.

The Basic Concept Behind Vanguard’s Major Tax Violation

Although the rules are very technical, the underlying concept is very basic. Income tax is based on ability to pay. If a business creates a good or service of value, it has income (ability to pay) equal to the difference between the value of the good/service and what it cost to create it. The business is taxed on that income; it can’t avoid tax by selling the good or service to someone with a common interest, like its owners.

These are rules that EVERY BUSINESS has to follow and they are not obscure! There are nearly 200 pages of Section 482 IRS regulations that prevent companies like Amazon, Microsoft, GlaxoSmithKline (GSK) and Vanguard from gaming the tax system to avoid tax. It’s worth noting that GSK manufactures pretty important products that help people stay alive, yet GSK paid the largest IRS settlement to date — $3.4 billion — for transfer- pricing violations. And obviously GSK, like Vanguard, could offer its products at lower prices if it paid less tax. I ask everyone who thinks Vanguard is the good guy the following question:

Of course Vanguard and GSK (and everyone else) have to obey current law, but if you were creating a new world and new law, who would you think has the better public-policy claim for a tax break in order to provide cheaper services, GSK, whose services primarily benefit average people with life-threatening conditions, or Vanguard, whose services primarily benefit the wealthiest top 10% of the population?

I will make one additional and very important point about Vanguard’s violations. All other companies with big IRS transfer-pricing litigation already pay many hundreds of millions or billions in income tax every year.

BUT prior to Danon’s submission Vanguard paid ZERO income tax.

This was completely lost on me because the press never focused on it. When I became aware of it I was floored. Danon’s New York complaint and Reuven Avi-Yonah’s report describe it very clearly. “At-cost” means Vanguard simply zeroed out its net income by charging the funds an aggregate expense ratio across all the funds equal to Vanguard’s total costs. The only effect of this was to avoid income tax because the funds would have (or at least should have) received post-tax profits. Other big companies pay billions in tax and fight over grey areas. Vanguard flat out illegally avoided ALL income tax. In doing so, they violated black-and-white rules that prohibit the artificial avoidance of profit.

How can it possibly be right that the largest mutual fund company in the U.S. paid zero income tax for decades?

The answer, of course, is that it is not right, in any sense. Tax lawyers agree that it is totally illegal, Vanguard has presented absolutely no justification, and it cannot deny that it owes the IRS billions of dollars.

*              *              *

Vanguard’s IRS Liability and Likely Insolvency

Key Facts

The following facts provide compelling evidence that Vanguard is insolvent or close to insolvent:

  • Tax experts agree that Vanguard’s structure is illegal and that Vanguard very likely owes billions of dollars of tax.
  • Vanguard has been unable to:
    • provide any legal justification for its structure;
    • deny Danon’s claim that the IRS was unaware of its structure before his submission;
    • deny that it owes the IRS billions of dollars.
  • The IRS told David Danon that his tax whistleblower claim was still open three years after his submission.
    • The IRS whistleblower office has established procedures for closing claims that lack merit within clear timeframes.
    • The IRS WB Office closes the vast majority of claims within a year or two of receipt.
    • The IRS Chief Counsel’s office has stated that, although the IRS is prohibited from disclosing audit information, a whistleblower can infer that the IRS is acting if his/her claim remains open for a long period.
  • How could Vanguard have amassed billions of dollars to pay its tax liability from “at cost” operations?
  • Vanguard claims to have operated “at cost,” and without profit. A corporation increases its assets/retained earnings through profits so how could Vanguard have amassed billions of dollars to pay its tax liability?
  • If Vanguard did retain billion of dollars, why didn’t it disclose this to fund investors, who own Vanguard?

Details and Links

Vanguard Insolvency

  • If a business’s debts exceed its assets, it is insolvent. An insolvent business may continue to operate, be able to meet debt payments when due, restructure or negotiate terms with its creditors, etc. and survive. However, insolvency generally requires a business to alter its operations in fundamental ways.
  • Here’s what we know about Vanguard’s tax liability.
    • Reuven Avi-Yonah, the most renowned transfer-pricing tax lawyer in the United States, has provided a “will” level opinion (the highest level of tax opinion, indicating virtual certainty under the law) that Vanguard’s at-cost structure illegally evades income tax and has estimated Vanguard’s liability in the tens of billions of dollars.

Reuven Avi Yonah Estimated Tax Liability of the Vanguard Group

Dennis J. Ventry Paper

    • Multiple nationally recognized tax journalists have all agreed with Avi-Yonah that Vanguard’s structure is illegal. Even a pro-Vanguard tax lawyer estimated Vanguard’s liability at $10 billion.[1]

The IRS’s Intensifying Fight Over Income Taxes

Vanguard Fund Fees to ‘Quadruple’? (Not so fast)

  • Vanguard’s tax violations aren’t everyday, garden-variety tax violations.
    • Avi-Yonah’s report, Danon’s New York complaint and Vanguard’s own securities filings indicate that Vanguard paid little or no income tax for decades.
      • “Since 1975, Vanguard and its subsidiaries (other than Vanguard Ireland) charge the Funds only the “costs” of providing services, which include wages and other expenses but do not include profit or a return on capital.”

Reuven Avi Yonah Estimated Federal Tax Liability of the Vanguard Group

      • “As a result, Vanguard shows little or no profit and pays little or no federal or state income tax despite managing Funds with nearly $2 trillion in assets.”

David Danon formerly sealed complaint against Vanguard

      • “By contrast, Vanguard provides services to its member funds on an at-cost basis, with no profit component, which helps to keep the funds’ expenses low.”

Vanguard 500 Index Fund Prospectus

 

Vanguard is the only large business in the history of the United States to pay zero federal income tax for decades.

  • Here’s what we know and don’t know about Vanguard’s assets and its financial statements.
    • For the first nearly twenty years of Vanguard’s existence, Vanguard’s SEC exemptive order required it to request permission from the SEC to obtain additional capital from the Vanguard funds. Prior to 1992 Vanguard had obtained a total of $25 million from the funds.
    • In 1992 Vanguard requested SEC approval to obtain additional capital of up to 40 basis points of total fund assets under management, which at the time would have equaled $356 million. In its request Vanguard stated that it expected it would only need $250 million through 1995.
    • Vanguard made no further requests to the SEC for any additional sources of funding after 1992, and to this day the funds’ annual statements indicate an aggregate $250 million of capital contributions to Vanguard.
    • Vanguard’s only sources of funds are (i) capital contributions from the funds and (ii) profits. But Vanguard claims to operate “at cost,” with no profit, so how could it have assets significantly greater than the $250 million of fund capital contributions?
    • As David Danon’s New York Complaint described, Vanguard established a secret (now infamous) $1.5 billion Contingency Reserve. Vanguard lied to investors and charged above cost to fund the Contingency Reserve but that’s only $1.5 billion. Vanguard cannot possibly have retained enough to pay its tax liability.
    • Vanguard tells the public that it is fine, the tax experts are all wrong; it pays the “fair and appropriate” amount of tax and claims “private” status, despite the fact that it is wholly owned by the publicly owned funds, so it doesn’t report its finances, including whether it is insolvent.
    • But we already know that Vanguard kept a secret multi-billion dollar Contingency Reserve as a “slush fund,” a “cookie jar” to do with as it wishes with no accountability to the investors who are its indirect owners, in direct violation of its obligation to provide at-cost services.

Vanguard has not even bothered to deny that it owns the hitherto secret Contingency Reserve. We only know about the Contingency Reserve because of Danon’s lawsuit. Why should we believe Vanguard when it says its finances are fine but it won’t tell us anything about those finances?

The IRS Whistleblower Office & Danon’s Whistleblower Claim

  • The IRS Whistleblower Office has established procedures to quickly close claims that have no legal basis or that it does not plan to pursue for administrative reasons (e.g., cost-benefit reasons) and closes the vast majority of claims the first year or two after it receives them. See chart on page 16 of following link:

Whistleblower Program Report to Congress, see page 16

  • David Danon’s whistleblower claim is open three and a half years after his submission.
  • Vanguard has never said that the IRS is not auditing it, that the IRS is not challenging its at-cost

structure or that the IRS has approved its structure.

  • The fact that Danon’s claim is still open after three years is virtual proof that the IRS audited Vanguard as a result of Danon’s whistleblower claim.

 

[1] Professor Hemel disclosed that the University of Chicago retirement plan offers Vanguard funds but failed to disclose that Vanguard and the University of Chicago have a close business relationship