Silver Wheaton circles the wagons against CRA challenge

VANCOUVER — The Canada Revenue Agency (CRA) has taken the first shot in what is likely to become a protracted legal battle with streaming outfit Silver Wheaton (TSX: SLW; NYSE: SLW), and the results could affect the company’s entire business model. In fact, senior vice-president and chief financial officer Gary Brown went so far as to infer the action represents an attack on a tenet of Canadian tax law.

On July 7 Silver Wheaton received a proposal letter from the CRA relating to income earned by its foreign subsidiaries outside of Canada. The crux of the dispute boils down to whether the company’s taxable income should increase by US$567 million for the 2005 to 2010 business years. Under preliminary estimates, that could put the company on the hook for US$150 million.

“They’re challenging us under the transfer pricing provisions of the Canadian Income Tax Act, which is very complex,” Brown explained during a conference call. “The CRA is essentially looking to recharacterize the income earned by our foreign subsidiaries to income earned by the Canadian parent company. We strongly disagree with that position. We believe in our business structure, which really operates under a tenet of Canadian tax law. There’s very little associated case law here and no precedent for this that we’re aware of.”

Generally, a company is taxable in Canada on its income earned within the country, while non-Canadian income earned by foreign subsidiaries is not subject to Canadian income tax. The CRA is effectively seeking to tax, within Canada, income earned through the buying and selling of precious metals outside of Canada by foreign subsidiaries from mines located internationally.

Silver Wheaton paid the Canadian governmernt regularly on income streams from its domestic contracts since its inception in 2004. Income generated outside of the country, however, was filtered through a subsidiary located in the Cayman Islands, which hasn’t been taxable under federal tax law.

“I want to reiterate that we remain confident in our business structure, which we believe is consistent with that typically used by Canadian companies, including streaming companies, that have international operations,” president and CEO Randy Smallwood added.

“We understand that Canadian tax law generally imposes income tax on the income that a corporation earns in Canada, while non-Canadian income earned by foreign subsidiaries is not subject to Canadian income tax. Management believes the company has filed its tax returns and paid applicable taxes in compliance with the law,” he continued.

Smallwood noted that Silver Wheaton has invested over $1 billion in mining assets in Canada, while its subsidiaries have provided nearly $2 million in funding for Canadian mining companies’ assets overseas.

Though Silver Wheaton would face a substantial payment if the CRA wins during the reassessment, the real risk to the company could be what happens to more recent, and future, income. Silver Wheaton took in 35 million equivalent oz. silver last year from various streaming arrangements, which equated to operating cash flows of U$432 million, or $1.20 per share.

According to the company’s annual financial statements, nearly US$300 million of that cash flow originated from seven agreements on mines outside of Canada, namely: Primero Mining’s (TSX: P; NYSE: PPP) San Dimas; Glencore’s (LSE: GLEN) Yauliyacu; Goldcorp’s (TSX: G; NYSE: GG) Penasquito; Vale’s (NYSE: VALE) Salobo; and Barrick Gold’s (TSX: ABX; NYSE: ABX) Lagunas Norte, Pierina and Veladero.

Scotiabank analyst Trevor Turnbull said a “worst-case scenario” for Silver Wheaton would see taxes and penalties owing from 2005 to 2014 approach US$912 million.

The good news for the company is that these cases, rare as they may be, tend to take time.

For example, Cameco (TSX: CCO; NYSE: CCJ) has a transfer-pricing dispute with the CRA dating back to 2008, and has received notices of reassessment for the taxation years 2003 through 2009. The uranium producer expects to go to trial for its 2003 reassessment in 2016, with a decision expected within 18 months after the trial concludes.

Cameco’s situation is different, however, since the company established a Swiss subsidiary to buy its own uranium, as well as uranium from “arm’s length” international sellers. The uranium was then sold to Cameco’s U.S. subsidiary for resale to buyers outside of Canada. For tax purposes, Cameco and its subsidiaries are deemed not to deal with one another. The CRA asserts the Swiss entity was a form of tax evasion.

If Silver Wheaton receives a reassessment notice from the CRA, it would file an objection within the required 90-day period provided under the Income Tax Act. In such a circumstance, the company would pay half of the reassessed amount of tax, interest and penalties. The cash, plus interest, would be refunded if Silver Wheaton succeeded.

“This doesn’t change our approach to near-term acquisitions,” Smallwood stressed when asked how the company’s business might be affected during the process.

“The streaming model works within Canada, where we are taxable. We have numerous significant streams in the country, so it works irrespective of how it’s treated and where it is located. We’re very confident in our structure. It’s a structure that numerous Canadian companies employ, and we’re very comfortable with our position,” Smallwood said.

“Our calculations are based on a worst-case interpretation of the CRA proposal letter and are intended to demonstrate that Silver Wheaton shares are oversold already,” Scotiabank’s Turnball wrote on July 7. “We believe the company has a strong case to argue that transfer pricing provisions do not apply.”

Scotiabank has a “sector outperform” rating on Silver Wheaton, with a one-year price target of US$30-per-share. The company dropped 12.5%, or $2.78, after the CRA proposal, en route to a $19.43 close at press time. Silver Wheaton has 404 million shares outstanding for a $7.9-billion market capitalization, and reported US$88 million in cash-on-hand at the end of March.