California Delivers Much-Needed Tax Relief to Cannabis Industry
In June 2022, California Governor Gavin Newsome signed Assembly Bill (AB) 195 into law, which, among other provisions, announced cannabis retailers will be responsible for collecting and paying the 15% cannabis excise tax come January 2023 — a responsibility currently belonging to cannabis distributors.
In September 2022, the California Department of Tax and Fee Administration released more details surrounding this change. Here are the high points.
• Be able to stop collecting the 15% excise tax from cannabis retailers
• No longer have to hold a cannabis tax account with CDTFA
Retailers will need to:
• Have a cannabis retailer excise tax permit from CDTFA
• File cannabis retailer excise tax returns online with CDTFA and pay the excise tax due
• Collect the 15% excise tax from their customers (based on the gross receipts from the retail sale)
• Claim a credit on the return for any excise tax paid to a distributor for cannabis purchased before January 1, 2023 or sold at retail on or after this date.
Additional announced provisions:
• Any unlicensed individual or cannabis business possessing, keeping, storing, or retaining cannabis or cannabis products for the purpose of sale (or who offers to sell) may be held liable for these cannabis taxes due to CDTFA with a penalty of 25% of the tax due (or $500, depending on which is greater)
• CDTFA can hold any member, officer, manager, partner, or other person associated liable for unpaid cannabis taxes, interest, and penalties when said corporation, partnership, limited liability partnership, or limited liability company fails to pay their cannabis taxes
• Any licensed individual who sells or transfers cannabis or cannabis products and does not report — or falsely reports — the sale or transfer in the cannabis track and trace system could be held liable for the cannabis excise tax.
On June 30, 2022, Governor Gavin Newsom signed Assembly Bill (AB) 195, effectively removing the cannabis cultivation tax altogether (formerly paid by growers at more than $161 per pound of cannabis flower), shifting tax collection of the 15% excise tax from distributors to retailers (beginning January 1, 2023) and introducing additional credits and incentives. The bill received bipartisan support and will provide relief from the high tax compliance burden smothering legal operators in the industry, which will in turn, combat the illicit cannabis market and make the legal industry more competitive.
Both in terms of tax liability and compliance responsibilities, this change is a big deal for those legal cannabis companies that have been struggling to survive under California’s cannabis tax regime, which, in some parts of the state, are the highest in the nation. Perhaps more importantly, it signifies that the state government is finally addressing the tax crisis that has made it nearly impossible for many California cannabis operators to grow and thrive.
Tax credits and incentives provided by AB 195
Hampered by complex regulations and high taxes, cannabis operators in the legal market have struggled, even as California’s tax revenue has soared. But the reforms, now official, provide a positive sign for legal operators that the state is moving in the right direction to support the industry.
Not only will AB 195 eliminate the cultivation tax and shift the excise tax to the retailer, but it will also put into action several other reforms. These include:
- Capping the excise tax rate at 15% for three fiscal years (though it could increase after July 1, 2025);
- Permitting social equity licensees to keep 20% of the excise taxes they collect so they can reinvest in their businesses;
- Equity licensees’ ability to collect a one-time $10,000 tax credit (to qualify, the firms must be licensed under programs to ensure representation in the industry from members of underserved communities/those harmed by prohibition policies);
- Lowering the number of workers that a business can employ before having to meet requirements to create a labor peace agreement; and
- Creating $40 million in available tax credits, which consist of:
- $20 million for some storefront retail and microbusinesses
- $20 million for cannabis equity operators
Decreasing the tax markup — and what the relief means for operators
California residents pay high taxes across the board. But the California cannabis industry and their customers suffer more than most. In addition to the 15% excise tax, there are sales and use taxes that can reach up to 11%, as well as local business taxes that can go as high as 15% depending on location. Prior to its elimination, the state cultivation tax was required by the Cannabis Tax Law to reflect adjustments for inflation — and many jurisdictions layer in even more taxes on distribution, manufacturing, and cultivation activities before the product even reaches the consumer.
Growers have long since been calling for relief, and in fall of 2021, wholesale prices collapsed, making it difficult for independent cultivation operators to make a profit. The governor said help was coming, although it was not until May of 2022 that the potential budget change that would cut the cultivation tax to zero was announced. This may not help growers who have already fallen susceptible to these sky-high taxes, but it delivers much-needed relief to those who are still currently struggling with rising inflation and reduced demand after peak COVID-19 pandemic levels.
The decrease also backs the governor’s commitment to minimize the presence of illicit growers on the scene. “Black market” operators that don’t pay taxes are able to offer products to their customers at much lower prices while still turning a profit. High tax rates that pass through to customers inevitably drive customers away and undercut the legal and licensed businesses, hurting those who are following the rules.
Why shifting tax collection from the distributor to the retailer is a win for the industry
While the removal of the cultivation tax presents a clear and immediate benefit, shifting the tax collection obligation from the distributor to the retailer is perhaps less obviously, but maybe even more, impactful to cannabis operators — and helps to put the legal cannabis industry on more equal footing with other industries.
Under the prior system, distributors were responsible for collecting both the cultivation tax from cultivators (by reducing the amount paid) and the excise tax from retailers. In the case of the latter tax, whenever the transaction involved unrelated parties (“arm’s length”) where the distributor is unaware of the ultimate selling price, the “average market selling price” that forms the tax base was determined using the CDTFA’s biannually published “mark-up” rate of 180% of the actual, wholesale price charged (reduced to 175% through the end of 2022). Consequently, for these transactions (which make up the majority of those in the industry), the mark-up rate has the effect of increasing the rate of the excise tax from 15% to 27%.
Theoretically, after paying the marked-up rate, retailers can recoup the outlay when they make the ultimate sale to the consumer, which (other than the cultivation tax) would make the tax scheme business-neutral (i.e., it should not create additional costs for businesses). However, in practice, there are several problems with California’s approach.
First, the timing of the tax payments under this system increases pressure on cash-flow for an already cash-strapped industry. Like many businesses, cannabis distributors do not always pay or get paid at the time of the transaction; instead, contractual payment terms often allow for a certain period to pass after transferring the goods before the cash consideration is due to the seller. This period allows the purchaser (i.e., retailer) a window of time in which to sell the goods and then have cash with which to satisfy the payment obligation to the distributor. But under California’s system, the excise tax is due to the state at the time it transfers to the retailer and before the infusion of cash from the consumer —placing the onus on the businesses to cover the consumer’s excise tax liability.
The second problem created by the system stems from the mismatch between the mark-up rate and reality. On the front end, most retailers need to pay tax on a presumed profit margin of 80% above the wholesale cost, regardless of what their actual margin would be (given spoilage, consumer demand, and the variety of market factors that affect cost). And even though the laws allow the retailer to simply pass through the cost, inventory-tracking and point-of-sale software often lack the complexity to do more than simply attach an additional 15% to the invoice (like how the software adds sales tax). In addition to this potential for leakage, retailers must contend with market price constraints as in any other industry — except in this industry, legal operators must also compete with a plethora of illegal operators who can undercut prices by ignoring the taxes.
AB-195’s changes, therefore, not only reduce tax for the industry overall, but also alleviate some of the compliance inefficiencies created by California’s cannabis tax regime. As of July 1, 2022, cannabis distributors are no longer required to collect and remit cultivation tax, and beginning January 1, 2023, they will no longer be required to collect and remit the excise tax. Thus, instead of using the mark-up rate to determine tax before it is sold and needing to “cover” the tax burden of the ultimate consumer, distributors will no longer be responsible for complying with a consumption tax. And in addition to alleviating cash flow issues, this shift also fixes retailers’ leakage problems by removing the unrealistic mark-up and allowing retailers to directly charge the consumer the exact tax due on products that actually make their way through the commercial process, and in the customer’s possession.
Our perspective on the tax changes impacting California’s cannabis industry
Many industry leaders are praising the administration for making real moves to rein in overbearing regulations for an industry that brings in a lot of money in tax revenue to the state ($817 million, to be exact, for fiscal year 2020-2021).
While these changes are a positive sign for the cannabis industry and its legal operators, many are still calling for additional reforms — in fact, some say taxes should be cut even more if legal cannabis wants a chance of competing on price with the illegal market. Cannabis retailers especially are expressing dissatisfaction, as they did not receive a direct tax cut like growers did with AB-195. Many critics also think social equity operators deserve even stronger aid as they are already at a disadvantage.
MGO is a national leader in both tax advisory and cannabis accounting and financial best practices. We can help you identify tax opportunities, prepare documentation, and take other steps to reduce your tax exposure. If you have any questions about California’s tax change and how it could affect your business, please reach out to our leading cannabis tax practice.
About the authors
Matt Sapowith is a tax partner at MGO with more than 13 years of tax planning and compliance experience in areas including corporate and partnership taxation, international tax, M&A transaction advisory, transfer pricing, state and local tax, R&D credit, and compensation planning. He has worked with companies in many industries, including cannabis. Contact Matt at MSapowith@mgocpa.com.
Nolan Shutler is a Director at MGO and National State and Local Tax Lead for SALT consulting and indirect taxes. Contact Nolan at email@example.com.