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Why Enforcing California’s Cannabis Excise Tax is Proving Harder Than Expected [Part 1]

Feb 22, 2018 2:53:00 PM / by Barry Lai

 “If you’re not confused, you’re not paying attention.” ― Tom Peters

January 1st will go down in history as a pivotal moment in the proliferation of legal cannabis across the globe. It will also be remembered as being a terribly clumsy period where everyone on both sides, industry, and regulators, just did their best. The Medicinal and Adult Use Cannabis Regulation and Safety Act (MAUCRSA) officially took over as the foundational law for regulated cannabis in California. And due to its nature as a hybrid voter proposition and a legislative body of work, we’ve been left with a less than perfect solution that enforcement agencies, including the California Department of Tax and Fee Administration (CDTFA), have done their best to implement. While there are various aspects that elicit confusion, let’s take a closer look at why the excise tax piece is so hard to enforce.

When excise tax was first thought up, it was truly a utopian vision of the future that would allow the state to collect the tax before the retail sales had even occurred. They planned to leverage the mandatory distribution layer carried over from MCRSA (shout out to the teamster) and turn distributors into tax collectors. In a world where competitive advantage is driven by a company’s ability to minimize tax exposure, retaining the distribution layer was a wise decision on the part of the state. With a last minute change allowing for self-distribution and cross-licensure, the state was able to quiet fears of distribution chokeholds, while retaining their tax collection mechanism.

When January 1st rolled around, very few in the industry understood what excise tax looked like in practice. The glut of the industry was under the impression there was a new 15% tax collected at the time of sale and remitted by the 15th of the following month. For many, it wasn’t until their first purchase from a distributor that they were introduced to the concept of arm’s length excise tax. This left many retailers wondering why they were being charged a tax the consumer is supposed to pay.

In the states effort to leverage the existing distribution layer to collect taxes, they created a binary system of tax calculation. The first and most common, arm’s length, is the pre-paid tax calculated using a predetermined average market price markup that’s constituted by a sale from a licensed distributor to an independent licensed retailer. For the purpose of tax collection, California deemed the average markup of cannabis products at 60%. This number is set to adjust every 6 months and the market is expected to fluctuate around this number like the fed adjusting interest rates. The second and less common, non-arm’s length, is the tax charged at the register on the full sales amount at 15% and remitted back to the CDTFA directly. A non-arms length sale occurs when inventory is transferred between licenses owned by a single entity or transferred between branches of a micro business. Traditionally, cannabis businesses have followed a 100% markup as a rule of thumb so, in the short-term, a product with an arm’s length tax will be significantly cheaper to the consumer than one with a non-arm’s length tax. Which, for the vast majority of California’s canna-businesses is good news seeing as they’ll be able to enlist the arm’s length tax calculation to reduce their exposure. Though, I do believe the state nailed the 60% mark up, the inevitable increase in competition and introduction of additional supply chain taxes are poised to bring margins crashing down to reality.

As the new regulations were coming into effect, a small group of operators — who had been following the developments from the state with a keen eye — began stockpiling products before being forced off the Prop 215/SB 420 supply chain they had blossomed with. Initially, there was no indication from the state that products purchased before Jan. 1 would have an excise tax levied on them because there was no mechanism in place other than the distributor tax gate. This was the first major flop on the state’s part. Weeks before the 1st, in the midst of a stockpiling frenzy the state announced all pre-Jan. 1 inventory would be taxed at 15%. Most slowed their buying down as there was no tax to avoid, but the wise continued to stockpile knowing the supply chain was going to be decimated.

At this point, there was still no indication on how to calculate the tax. Just an announcement stating all pre-Jan. 1 inventory would have excise collected on it and that you had a 6-month transitional period to sell through it. The tax collected would need to be paid by the 15th day of the following month to a distributor you had formed a relationship with. This was the first sign that a wave of mass confusion was headed straight for California’s shores. The state didn’t realize most distributors operating in January were existing large manufacturers, like Kiva, and not pure distributors who would be willing to assist in tax collection. Additionally, the state was remiss in communicating to retailers that the excise tax payments made en masse to fledgling distributors would need to be held in good faith until the distributor made their quarterly tax payment by April 30th. In a normal industry, this type of exchange would be done through an escrow account but in cannabis with no banks, this wasn’t possible. In lieu of this federal stepping stone, the state asked retailers to trust a distribution company, who in many cases, may not be bonded or permanently licensed, to take on the liability of holding hundreds of thousands of dollars generated by someone else’s operation… which, as you can imagine, distributors are not insured to do — obviously, things are just not adding up.

With so much on the line, it’s no surprise retailers have been searching for ways to hone in on their exact tax obligations with as much certainty as possible. While the state continues to tinker with how the new regulations will be shaped and enforced, software providers are on the front lines, tasked with providing interim solutions to meet the growing demands of the evolving regulatory landscape. The reality is, comprehension of the laws is only half the battle, it’s the implementation aspect that’s going to win the war, and there are very few players in this space capable of delivering that kind of ammunition — until now.

Continue to: How Treez is Helping Retailers Implement California’s Utopian Vision of Cannabis Taxes [Part 2]

Topics: California, cannabis, compliance, excise, taxes

Barry Lai

Written by Barry Lai