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California, like a growing number of other states, allows and taxes medical and recreational use of marijuana. In this article, Harris Bricken's Jim Hunt discusses California's new marijuana taxes and what practitioner's need to consider for compliance.
By Jim Hunt
Jim Hunt is a frequent blogger ( www.cannalawblog.com) and speaker on local, state, and federal tax issues, especially those related to the ever-changing cannabis industry and the regulations governing it. He recently served two terms (2014-2016) as Chair of the State and Local Tax Committee of the Washington State Bar Association (WSBA) and recently served as the Chair of the Continuing Legal Education Committee of the WSBA.
California has a long history of approving the use of cannabis under specific conditions. In 1996, California enacted the Compassionate Use Act of 1996 (“CUA”). Under the CUA, registered patients could use medical marijuana for relief of certain medical conditions; however, adult recreational use was still prohibited.
On November 8, 2016, The Citizens of California approved Proposition 64, The Control, Regulate and Tax Adult Use of Marijuana Act (“Prop. 64”). Prop 64 allows for the legal recreational use of cannabis. Prop 64 created two specific tax bases. The first, was a Cultivation Excise Tax based on a fixed dollar amount per ounce of flower and leaves. The second, was a Cannabis Excise Tax equal to 15 percent of the retail sales price.
Then on June 27, 2017, the Governor of California, Jerry Brown, signed Senate Bill 94, the Medicinal and Adult Use Cannabis Regulation and Safety Act (“MAUCRSA”). This new law integrated the regulation of the medical and adult recreational market into one regulatory framework. Under MAUCRSA, the Cultivation Excise Tax remains a tax measured by a fixed dollar amount per ounce. However, MAUCRSA modified the structure of California's Marijuana Excise Tax from a tax imposed on 15 percent of the gross retail sales price to a tax imposed on 15 percent of a predetermined average price. In addition, MAUCRSA created a framework for administering excise taxes. Below is a summary of the key provisions of the law which is effective January 1, 2018.
MAUCRSA, imposes a 15 percent excise tax on “the average market price”(“AMP”) of any retail sale by a cannabis retailer. Cal. Rev. & Tax. §34011(a). Potentially, there are two AMP's. The first AMP is arm's-length and based on good faith negotiation in the open market, in which case the AMP is wholesale cost plus a mark-up determined every six months by the State Board of Equalization (“SBE”) or its “successor”. Cal. Rev.& Tax. §34010(b)(1).
The second AMP is based on a “non-arm's length transaction,” in which case, the AMP is the gross receipt from the sale. Cal. Rev.& Tax. §34010(b)(2). Given the July 1, 2017 restructuring of the SBE, it is unclear if the AMP will be set by the current five-member Board of Equalization or the newly created California Department of Tax and Fee Administration (“CDTFA”).
The determination of the AMP is crucial in determining how the tax is collected and remitted. Though the cannabis consumer is ultimately subject to the Marijuana Excise Tax, it is the Distributor that must collect the Tax from the Retailer and, in turn, remit tax to the CDTFA.
On “non-arm's length transactions”, the Distributor must collect the tax from the retailer when the retailer sells cannabis product to the consumer, but in no event more than 90 days after the Distributor's sale to the Retailer. For “arms-length” transactions, the Distributor must collect the tax from the retailer “on or before 90 days after … the sale [from the distributor] to the retailer.” Cal. Rev. & Tax. §34011(b)(1).
The Marijuana Excise Tax is in addition to sales and use taxes imposed by California's state and local governments and it is included in gross receipts for purposes of computing sales/use tax. This essentially creates a tax on a tax. Cal. Rev. & Tax. §34011(c), (d).
Under MAUCRSA, California's Cultivation Tax is imposed on the cultivator after the cannabis is harvested and enters the commercial market. Cal. Rev. & Tax. §34012 (a). For cannabis flower, the tax is $9.25 per dry-weight ounce. For cannabis leaves, the tax is $2.75 per dry-weight ounce. The Board has the authority to create a tax stamp/tax container system whereby proof of tax payment is evidenced by either a stamp or a pre-approved container.
The Cultivation Tax is collected on the “first sale or transfer” of cannabis by the cultivator to the manufacture. Cal. Rev. & Tax. §34012(h)(2). What constitutes a first sale is not defined in the statutes. For a transfer of cannabis product to a distributor, this tax is collected when the cannabis “enters the commercial market.” Cal. Rev. & Tax. §34012 (h)(1). When Cannabis “enters the commercial market” is defined as the time when the cannabis or cannabis product has completed all required inspection and testing. Cal. Rev. & Tax. §34010(m).
The cultivator is subject to the Cultivation Excise Tax but is relieved from further liability if the manufacturer or distributor provides detailed documentation that tax was paid. Cal. Rev. & Tax. §34012(h). Under MAUCRSA, the Board has the authority to prescribe a substitute method and manner for collecting and paying the Cultivation Excise Tax, and it is likely the collection and payment process will be fine-tuned. Cal. Rev. & Tax. §34012(h)(2)(B).
Under MAUCRSA, a county may impose a tax on the privilege of engaging in a wide variety of cannabis activities, including cultivating, manufacturing, and sales. The counties have some latitude to structure their tax including: the tax rate, method of apportionment and manner of collection. The county tax may be imposed in addition to the various other local ordinances taxing cannabis business activities. Cal. Rev. & Tax §34021.5. Furthermore, Marijuana excise taxes do not limit or replace other city or county taxes. Cal. Rev. & Tax §34021. However, local governments may not impose a cannabis sales and use tax. Cal. Rev. & Tax §34021.5(d).
MAUCRSA, gives the Board wide latitude to issue regulations to implement the law. For example, much of the detail regarding collection and payment of tax for retailers and distributors will be determined in regulations. Cal. Rev. &Tax. §§34011(b)(1);34012(h). In implementing the Cultivation Excise Tax, the Board is granted authority to implement the tax through a tax stamp or product bag system. Cal. Rev. & Tax §34012(d). Accordingly, cannabis businesses are advised to monitor the drafting of regulations which will determine important compliance issues.
Second, businesses must understand that even one failure to comply with the law could put your entire operation at risk. For example, a cannabis businesses failure to pay tax will result in a minimum penalty of 50 percent of tax due and “shall be subject to having its license revoked”. Cal. Tax. Rev. & Tax §34013(e). Furthermore, the Board is authorized to seize cannabis and cannabis products sold without proper documentation of tax payment. Cal. Tax & Rev. §34016 (c).
Finally, tax practitioners must decide how to treat these excise taxes for federal income tax purposes. Under IRC §280E, a person engaged in a trade or business that consists of trafficking in a controlled substance such as cannabis, may not deduct expenses associated with that trade or business. One exception, are costs included in cost of goods sold under IRC §471. Such costs are not subject to IRC §280E and; therefore, not included in taxable income. State excise taxes included in cost of goods sold for financial statement purposes may also be included in cost of goods sold for tax purposes. Treas. Reg. §1.471-11(c)(2)(iii)(a).
There are several open questions regarding the applicability of IRC §280E to the California Cannabis tax. Is the Cannabis Cultivation tax incident to and necessary for the further production of cannabis and, therefore, included in cost of goods sold? Is the Cannabis Excise tax a price adjustment or an expense disallowed under IRC § 280E? See,CCA 201531016 (Washington Marijuana Excise Tax is a tax paid in connection with the disposition of property by a trade or business and not a deduction as defined in IRC §164. Accordingly, the Washington excise tax is a price reduction not subject to limitation under IRC §280E).
California's new marijuana taxes are complex. California regulators will face may issues regarding the implementation of the law. California cannabis cultivators, distributors, and retailers must also consider the federal tax impact the law will have on the economics of their business.
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