The potential intervention of the taxman continues to be an underappreciated investment risk—but not in the way you’re used to hearing about in headlines.
Most advisors concern themselves with legislative changes in the way investments are taxed, whether those investments are stock options, insurance policies or trust structures.
Often forgotten is CRA’s influence on corporate taxes and the disruptive effect that it can have on the share prices of companies owned by clients.
Silver Wheaton Corp.
In July 2015, Silver Wheaton surprised the market when it announced that it had received a proposal from CRA to reassess the company’s 2005 to 2010 tax years. A proposal letter is like a heads-up that an actual reassessment is coming. The shares closed down 12% on the news.
CRA was seeking to increase Silver Wheaton’s taxable income for the period by $715 million, which would result in taxes owing of $201 million. Added to transfer pricing penalties (more on that later) and interest, the total amount owing under the proposal was $353 million.
Because CRA doesn’t normally reassess all years at once, the general market assumption has been that similar taxes will eventually be owed from 2011 to present. So, the total amount owing could reach $600 million, depending on further penalties.
The potential hit to the value of Silver Wheaton shares is not just in the cash amount that it might owe, but also in the fact that the cash outlay could delay future acquisitions, potentially slowing growth. Further, if the transfer pricing agreements are disallowed, that could affect the company’s future after-tax margins.
In September 2015, the company received the reassessments, which were consistent with the proposal. The company will likely receive reassessments for additional years sometime in 2016. The process will be slow and, if the company takes the issue to court, it could be many years before a resolution is known to investors. Silver Wheaton has officially filed a notice of objection to the reassessments and the company has stated that its tax returns are consistent with Canadian law.
If the transfer pricing issue seems familiar, it’s because Cameco Corp. is currently embroiled in an ongoing battle with CRA. Back in 1999, Cameco set a $10 uranium transfer price between its Canadian and Swiss divisions, which CRA alleges has resulted in excess revenue shifting to Switzerland (see “Tax games: Are some companies playing with fire?” AER November 2014).
Transfer prices are what one division of a company will pay another for a good or service (an intercompany charge). Since management chooses the transfer prices, they effectively determine the income of each division, and can shift income from one division to another. The goal, so to speak, is to minimize tax by shifting more income to international subsidiaries with lower tax rates.
As Silver Wheaton notes in its latest annual report, “A significant portion of the company’s operating profit is derived from its subsidiaries, Silver Wheaton Caymans, which is incorporated and operated in the Cayman Islands; and historically, Silverstone Resources (Barbados) Corp., which was incorporated and operated in Barbados, such that the company’s profits are subject to low income tax.”
Silver Wheaton is a fairly unique company in the mining sector because it’s generally regarded as one of the founders of the streaming industry.
Streaming businesses pay operating mining companies for their production of by-product metals. For instance, Silver Wheaton will purchase the silver production from a gold miner, or the gold production of a copper miner.
In exchange for a large upfront payment that usually helps the miner finance its project, the streaming company (Silver Wheaton) will buy the future production (usually at a low per ounce cost) for a set amount of time.
In this manner, Silver Wheaton avoids many of the risks of operating the mines, and takes on mostly financing and investment risk. Most of its operations are, therefore, in the management realm: identifying opportunities, raising financing, and marketing and selling the resources acquired.
Qualified personnel located in lower tax jurisdictions can legitimately carry out some of these functions. Canadian employees also carry out many of the key functions. Silver Wheaton management decides which subsidiaries performed the work.
CRA argues that much more of the key functions, assets and risks were actually attributable to the Canadian operations, and the transfer prices should have reflected that and resulted in more taxable income occurring in Canada.
Given a July 2015 court ruling in the Cameco case (which is at a more advanced stage), it will likely come down to CRA identifying what it believes are the appropriate transfer prices, and whether Silver Wheaton is amenable to a settlement. Ultimately, there is no single agreed-upon process for determining the transfer price. And the situation is complicated by the fact that there are fewer comparable streaming deals versus what would be available for analysis amongst more traditional mining transfer-price cases.
Identifying problems early
No one wants their stocks to fall due to a surprise intervention by CRA, so advisors need to be aware of the tax rates of the companies that they buy for clients.You should flag any that seem to have exceptionally low effective tax rates—in the single digits, for instance.
There are sometimes other tip-offs that the CRA might audit a company and deliver a hit to the share price. Some CRA cases have themes. Often, the agency targets many companies for the same issue, but it takes time to cycle through them all. The theme of transfer pricing reassessments is common to Cameco and Silver Wheaton. In “Who will settle with CRA next?” (see also AER June 2015), we saw how CRA was auditing companies based on the eligibility of purchased tax losses concurrent with when they converted to corporations from income trusts.
For several years, the CRA had been issuing reassessments to dozens of companies. We used this trend to identify Total Energy Services as a likely candidate to receive a reassessment from CRA. The company received a CRA notice in September 2015, stating that it owed $11.5 million in additional taxes and interest.
Who will settle with CRA next?
CRA has been revisiting the tax filings of several former income trusts because of how they applied tax losses acquired from other companies. Some companies have decided to settle with the taxman, while others have chosen to fight. Advisors should focus on who might be next and what the potential impact is on valuation.
Tax losses are valuable because they allow companies to reduce future taxable income when they’re profitable. A company may sell its tax losses if it does not think it will be able to use the losses before they expire. Normally, companies aren’t allowed to use the tax losses of companies in unrelated businesses.
For instance, an energy company can’t buy losses from an airline.There have been settlements with 20 or so former income trusts that started to receive reassessment notices as far back as 2013. That number will continue to increase and, combined with what seem like reasonable settlement terms, advisors need to question companies that are digging in for a fight based on a tax loophole that touches on tax avoidance.
From an investment perspective, we think it’s best to assume the losses are worthless. This viewpoint is conservative but reasonable given the spate of settlements.
–Al and Mark Rosen, from AER June 2015