Calif. lawmaker rethinks tax break Vanguard didn't seek: UPDATE

More in my column in the Philadelphia Inquirer 5/16/16
UPDATES FRIDAY 5/13: California Assemblyman Mike Gatto, D-Los Angeles, tells me he decided to write legislation to give Vanguard Group a state income tax break last winter, after an online financial-news commentary made him worried about the impact of a whistleblower's tax complaints on the largest mutual fund company.

As a proud Democrat, Gatto says he mostly supports whistleblowers: "They are usually doing a very good job for society." But he likes Vanguard so much, and he was so worried Vanguard could owe so many billions that it could feel pressure to raise fees, that, "in this case, I'm not sure this guy is doing the Lord's work."

In fact, Gatto's first plan wasn't to cut California state revenues -- it was to write a law that would "prevent whistleblowers from collecting" from Vanguard, he told me: "Take away the motivation for somebody to file these 'gotcha' lawsuits." Only when legislative lawyers were dubious did Gatto change his proposal: it now gives a state income tax exemption to Vanguard and any investment company structured the same way.

I pointed out to Gatto that his press release trumpeting the tax break's passage through an Assembly committee earlier this week contained a string of factual errors, including inaccurate claims that Vanguard's structure is "non-profit."

"This has not been the most accurate of our press releases," Gatto acknowledged, blaming the lack of financial acumen among California's legislative communications staff. 

"Our bill needs some pausing, too," Gatto confessed. "The bill isn't done yet." Gatto says he's now thinking about abandoning the tax break -- and going back to his earlier program of blocking whistle-blowers from any rewards for reporting illegal conduct at Vanguard and any similar mutual-fund company.

Meanwhile: "While we are now aware of Assemblyman Gatto's proposal, we were not consulted about the bill," and aren't aware of  similar efforts elsewhere, Vanguard spokeswoman Katie H. Hirt told me. "We will not speculate" on the impact of a potential California tax break on Vanguard's bottom line, or what it would do with the money.

THURSDAY 5/13: A one-page law that would exempt Malvern-based Vanguard Group, a private corporation that operates the largest and fastest-growing mutual fund business, from having to pay California state income taxes, on Monday passed that state's Assembly revenue and tax committee in a 9-0 vote.

Bill 2490 -- read it here -- would amend the state Corporation Tax Law so that "a mutual fund company owned by investors in the mutual funds that it serves is not subject to tax." The bill faces deadlines: if Appropriations approves by May 27 and the whole Assembly passes it by June 3 it will move on to the state Senate.

The proposal is sponsored by Assemblyman Mike Gatto, D-Los Angeles, who in a statement said he seeks to close a "bizarre loophole" in California's tax law, which, like federal tax law (as the bill notes), requires companies that buy services from affiliates to pay market prices, instead of setting special prices that could lower their taxable income.

Gatto added that Vanguard's low fees have made it "extremely beneficial" to California investors.

Gatto also cited a "bizarre" whistleblower complaint that has raised the issue of whether Vanguard, by charging only the "cost" it incurs, instead of the market price, for services it provides affiliated mutual funds, has been systematically underpaying its federal and state income taxes.

Former Vanguard tax lawyer David Danon has filed complaints with the IRS and with California and other states urging them to collect what he says are unpaid back taxes. Texas last Spring paid Danon $117,000 for reporting taxes Vanguard owed so the state could collect them. "Vanguard pays its fair share of taxes at the federal and the state level," said spokeswoman Hirt.

But California shouldn't want Vanguard's tax money, Gatto said. He would prefer the state reward Vanguard with tax-free status so it can continue providing "low-cost services to its customers." His proposal does not require the company to pass tax savings to shareholders. Vanguard's spokeswoman declined to say what it would do with any increased income, noting the bill hasn't passed.

Eric Menjivar, Gatto's spokesman, said his boss had the bill drafted by state lawyers on his own, without any request from or contact with Vanguard. I asked why language in his press release echoed Vanguard marketing materials. "He reads a lot," Menjivar told me.

The bill itself doesn't call Vanguard a nonprofit. "Vanguard is not a nonprofit organization; specifically, we do not have 501(c) status," according to spokeswoman Hirt. "We refer to ourselves as a client-owned firm that operates at cost."

I asked Menjivar if California legislators would also support eliminating taxes for low-cost retailers Amazon.com and Wal-Mart Stores, if that would help them sell products cheaper.

Those companies aren't owned by their customers, Menjivar pointed out.

Given Vanguard's lack of investor leverage over its governance and its non-disclosure of management compensation incentives, Vanguard "in reality" does business  much like other privately-owned mutual fund companies, according to Assoc. Prof. John Morley's 2014 article in the Yale Law Journal here.

While "Vanguard nominally combines the ownership of the management company and the funds by placing the management company's ownership in the hands of the funds," Morley writes, "Vanguard is not meaningfully different from any other mutual fund management company." Since its customers lack "meaningful" control over or equity in Vanguard Group, they are "not truly the 'owners' of the management company any more than the fund investors in any other mutual fund complex are."