Reducing costs is typically one of the main reasons one organization buys or incorporates a subsidiary, instead of just going into the marketplace for what they need. Will that now be illegal if it reduces the total tax payments of the formerly separate organizations, as a side effect? That seems like a pretty dramatic intrusion into business decision-making.
Say a non-profit hospital ordinarily purchases services from a for-profit testing lab. The testing lab receives market-rates for its services, and pays tax on that income. Now, say the hospital purchases the testing lab, but continues to operate it as a for-profit subsidiary. But the hospital makes the subsidiary sell its services at cost, eliminating the subsidiary's tax liability while boosting the hospital's non-taxable surplus. Maybe that's still okay. But now say instead of a testing lab, the subsidiary is an advertising agency. Same result?
It's worth reading Matt Levine's take on this: http://www.bloombergview.com/articles/2015-11-25/calpers-fee... (scroll down to "Vanguard and taxes").
The problem is not the acquisition of the for-profit entity by the non-profit entity. The problem is when those entities don't interact at arm's-length.
This would clearly be absurd, the management company is happy with their fee, and the co-op members are happy. The fact that "normal" corporate structure would pay more in tax shouldn't really factor into the decision since the question should be, given your corporate structure, are you paying taxes.
> In the meantime, the co-op grows 10-fold, but the contract with the management company doesn't change (somehow, let's just assume the co-op doesn't require active management, they just need guidance occasionally or something)
The question isn't what a "normal management structure" would cost. It's what the affiliated entity would normally charge in the market for the same service. Vanguard's sells its investment management services to the mutual fund at cost because it's owned by the mutual fund. It wouldn't do that otherwise.
So to make your example comparable, the co-op buys the management company, and makes it operate at zero profit. So the question is: would the management company be happy making zero profit if it weren't owned by the co-op? The answer is: probably not.
edit: I should add, that I'm fairly certain that the employees at vanguard are in fact getting paid.
edit2: So the question is should we look at whether the employees/contractors at vanguard are getting paid market rate, or whether vanguard as a whole is charging market rate to the investors. My comparison to the hospital co-op was that it's unfair to compare apples-to-orangutans.
I can see that they could have run afoul of some tax rules due to their structure, but it seems disingenuous to argue that they should charge management fees just as high as their active management competitors. (But sure, maybe they should charge more than they do now.)
Then again, as an owner of Vanguard index funds, maybe it's hard for me to be rational in this case. >:D
At what point do these legal distinctions begin to take effect? If a friend and I pool resources and purchase some stock, then later sell it at a profit and split the trading fees, did we somehow owe unpaid tax?
It seems like this is a tax against vertical integration in financial services, which I'm not sure I understand the need for...
Consider, for example, a tax dodge Samsung is alleged to have engaged in. Samsung Electronics makes products in South Korea, then sell them at cost to Samsung Distribution, which is an affiliated company in a low-tax jurisdiction. Samsung Distribution then exports the products at market price to Best Buy, etc. Samsung Electronics books little or no profits in South Korea--all the profits are booked by Samsung Distribution in the low-tax jurisdiction.
There is also a corporate-entity angle to this. Operating as a separate corporation has benefits: if one goes bankrupt, its creditors cannot reach the assets of a related entity. But if transactions between related entities are not arm's-length, it's easy to shift money around between them and abuse the protections of separate corporate forms by, e.g., leaving riskier lines of business undercapitalized in case of a tort judgment.
If I call up an old mentor and he gives me useful, money saving tips that I employ to amplify my business's profits, should he be taxed "as if" he billed me as a consultant?
If employees of a for-profit startup ask questions on a mailing list they're members of, should the mailing list be taxed as if it were selling consultancy services?
And how (too tired to come up with an answer myself) would this case differ from Vanguard? I'm guessing it has to do with the fact that the Vanguard investment management company is charging other people market price for its advice, but what if my mentor did that? Are we now in a world where, if I sell a good for-profit to anyone, I must pay taxes on the income I would have gotten, any time I give that good to someone else for free?
What if my wife's a professional childcare provider? Do I have to pay taxes on the imputed income from when she's alone with our kids? (There are non-G-rated versions of that question, btw.)
(Honest questions, all. Don't know if I'm missing something here or misunderstanding the tax threat model.)
But the law is there for a reason, to prevent tax dodges. Like selling a patent to fully owned foreign subsidiary in a low tax jurisdiction for $1. Then having that subsidiary collect royalties of millions from the parent domestic company. The expenses (of the royalties) are deducted, and tax is only payed on the much lower profit. The foreign subsidiary pays local (lower) taxes and keeps the profits in a foreign account. This is clearly a tax dodge. If you allow the IRS to levy tax on market rates for patent transfers and royalties, they can can redo the accounting to figure out what a fair tax would have been without the accounting games.
I'd really like to see the law changed to allow Vanguards actions (presuming they are indeed in violation) but I'd also be worried about adverse consequences.