Too Big to Tax? Vanguard and the Arm’s Length Standard

10 Pages Posted: 29 Sep 2015 Last revised: 25 May 2017

Date Written: September 21, 2015


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.

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 Treags. 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 is a C corporation and the Funds are Regulated Investment Companies (RICs) not taxable at the corporate level, so this situation results in avoidance of billions of corporate taxes.

The IRS has not taken action on Danon’s whistleblower complaint, nor has the NY Attorney General intervened in his qui tam lawsuit against Vanguard. Given the millions of Americans that have invested in Vanguard funds and the billions in tax at stake (which would presumably be borne by the investors in the Funds if Vanguard raises its fees to include the tax), this case raises the question: Is Vanguard too big to tax?

This article will argue (a) that the Vanguard “at cost” pricing is unsustainable under the arm’s length standard, and that the IRS will win in court if it challenges Vanguard’s transfer pricing; (b) that the Vanguard case illustrates some of the problems with the arm’s length standard and would have been avoided had unitary taxation principles been applied to Vanguard and its Funds.

Keywords: mutual funds, taxation, transfer pricing, arm's length standard

JEL Classification: H26

Suggested Citation

Avi-Yonah, Reuven S., Too Big to Tax? Vanguard and the Arm’s Length Standard (September 21, 2015). U of Michigan Law & Econ Research Paper No. 15-015, Available at SSRN: or

Reuven S. Avi-Yonah (Contact Author)

University of Michigan Law School ( email )

625 South State Street
Ann Arbor, MI 48109-1215
United States
734-647-4033 (Phone)

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