How Much Profit Should Vanguard Make on Managing Your Assets?

Justin Fox reports on a weird transfer pricing issue that I have been following:

Near the end of last month, 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. Isn’t that outrageous!?!?! I mean, seriously, how shameless can these guys get? That, in short, is the argument Vanguard tax lawyer turned whistle-blower 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. More on that in a bit. But the underlying reasoning is simple: Vanguard is cheating state and federal tax authorities by charging its customers much less than other fund companies do.

We’ll return to the transfer pricing later as well. I’m not a tax lawyer so forgive me if I get this one wrong. Vanguard’s customers are also its shareholders. If they did raise the fee so as to make C corporate profits taxable at 35% - would not their rich customer/owners get a deduction off their taxable income which may now be at a rate of 39.6% (under Bernie make that 52%)? OK – let me turn to something I do get – transfer pricing:

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

I have a lot of respect for Avi-Yonah as a tax professor but when I read his report, I realized any competent economist for Vanguard could push back. And the reason is in that Morningstar report:

The asset-weighted expense ratio for passive funds was just 0.20% in 2014, compared with 0.79% for active funds.

Avi-Yonah’s analysis would take the overall average of 0.64% for the intercompany fee for Vanguard which is four times its costs. A profit to cost ratio of 300% sounds incredibly high. But Vanguard is a passive fund not an active fund. So wouldn’t the appropriate comparable fund analysis suggest a fee closer to 0.2% of assets under management so the profit to expense ratio would be around 25%? Justin Fox does a nice job of presenting whether or not the IRS could or even should pursue this. But if they did – one would hope their transfer pricing analysis would be a bit better developed.