CA Cannabis Excise Tax – Extraction – Processing

CA Cannabis Excise Tax - Extraction - Processing
CA Cannabis Excise Tax – Extraction – Processing

This post is the second in a series of posts we expect to publish related to CA Cannabis Excise Tax – Extraction – Processing.  Our previous post focused on a simple example involving the collection, reporting, and remittance of California’s Cannabis Excise Tax (“CET”) related to flower, it was complicated. When we begin to move to extraction, processing, and distribution, the complexity expands, almost exponentially.  We continue to be amazed by the number of comments relating to the CET that merely regurgitate information published by the California Department of Tax and Fee Administration [“CTDFA”]. The example in this post illustrates some of the inadequacies of the CDTFA’s analysis and propose some solutions.  The inadequacies of CDTFA’s analysis are principally the product of:

  • The failure of CDTFA to address the realities of the cannabis supply chain.
  • The failure of CDTFA to address the complexities of the calculation of CET.

In January CDTFA published the two CET examples that follow:

The first calculation is the CDTFA’s “arm’s length” example.

Example #1 – The retailer purchased five pounds of cannabis flowers for $7,500 and 50 cannabis candy bars for $300 in an arm’s length transaction. The average market price in the case of an arm’s length transaction is the wholesale cost of the cannabis plus a markup. This example assumes a 60 percent markup.

The wholesale cost of flowers

$7,500

Markup for flowers ($7,500 × 60%)

$4,500

Average market price of flowers

$12,000

The wholesale cost of candy bars

$300

Mark-up for candy bars ($300 × 60%

$180

Average market price of candy bars

$480

Total average market price ($12,000 + $480)

$12,480

Total cannabis excise tax due ($12,480 × 15%)

$1,872

The distributor is responsible for reporting and paying the $1,872 CET to the CDTFA on his/her cannabis tax return. The distributor is not responsible for verifying the retail selling price of the cannabis. The CET is based on the average market price. In an arm’s length transaction, the average market price is not based on the retailer’s gross receipts from the retail sale.

The second calculation is the CDTFA’s assumed “non-arm’s length” example.

Example #2 – The retailer, which is part of a microbusiness, sells four pounds of cannabis flowers for $9,600 and 25 cannabis candy bars for $500 to their customers (the consumer). This is considered a non-arm’s length transaction because the microbusiness is both the distributor and the retailer. The average market price in the case of a non-arm’s length transaction is the cannabis retailer’s gross receipts from the retail sale.

Gross receipts from sale of flowers

$9,600

Gross receipts from sale of candy bars

$500

Total average market price ($9,600 + $500)

$10,100

Total cannabis excise tax due ($10,100 × 15%)

$1,515

The microbusiness is responsible for reporting and paying the $1,515 cannabis excise tax to CDTFA on their cannabis tax return.

CDTFA’s simplistic explanation of the collection, reporting and remittance of the CET is inadequate for the real world business. A real business world example illustrates the inadequacies of CDTFA’s analysis. The inadequacies of CDTFA’s analysis exist whether or not a micro-business is involved.  The weakness in CDTFA’s analysis principally arises from the fact multiple transfers of cannabis material and multiple transformations of cannabis material are likely to occur between a cultivator and a consumer.

CDTFA provides the following as “official” conversion rates:

Weight Conversion Chart

1 Gram = 0.035 Ounces = 0.001 Kilograms

1 Ounce = 28.35 Grams = 0.0625 Pounds

1 Pound = 453.6 Grams = 16 Ounces

Our Example – Grow LLC is a licensed cannabis Cultivator. Grow LLC harvests cannabis trim with a total weight of 1,000 pounds (wet weight). Grow LLC sells the entire 1,000 pounds [16,000 ounces] to Ed the Extractor for $20/pound based on the wet weight. Ed the Extractor will extract oil from the trim for medical use.  Ed the Extractor is a California cannabis micro-business that is licensed for Manufacturing, Distribution, and Retail.  Ed the Extractor picks up the trim from Grow LLC and transports the trim to its facility.  The California Cannabis Cultivation Tax (“CCT”) that Grow LLC is required to pay over to Ed the Extractor for subsequent payment to CDTFA is $20,640 [16,000x$1.29/ounce].  Ed the Extractor assumes Grow LLC’s CCT liability as an addition to the purchase price for the trim. The complexity of CA Cannabis Excise Tax – Extraction – Processing grows.

Ed the Extractor dries the trim and extracts cannabis oil from the 16,000 ounces of trim.  Ed the Extractor produces 750 ounces [21,262 grams] of raw oil. Ed the Extractor’s cost of extraction and testing the 21,262 grams is $23,200 including the costs incurred in picking up the raw material. The value of the oil is $5.00/gram for a total value of $106,313 in a bulk sale.

The CET Ed the Extractor owes to CDTFA is $25,515. The CET is based on the value of the oil increased by 60% to a presumed eventual retail sale value of $170,101 [$106,313 x 1.6 = $170,101]. The CET is $25,515 [$170,101 x 15% = $25,515].

We note that the costs incurred by Ed the Extractor are part of his Cost of Goods Sold (“COGS”) for income tax purposes, but these costs are not part of the CET computation. We also note that Ed the Extractor is responsible for remitting the CCT of $20,640 to CDTFA.  Ed the Extractor owes CDTFA $46,155 for CCT and CET.

Ed the Extractor sells the entire lot of 21,262 grams of raw oil to Boris the Baker, a California cannabis edibles manufacturer, for $106,313 plus $25,515 (CET). The CET must be separately stated in order to facilitate tracking by CDTFA as well as other businesses.  Ed the Extractor’s gross margin is $42,473 [$106,313 – $20,000 – $23,200 – $20,640 (CCT) = $42,473].

Boris uses an entire lot of raw oil together plus $17,000 of ingredients and $22,000 of labor to produce 500 packages [600 cookies per wholesale package] of Prune flavored cannabis cookies which have a total wholesale value of $220,000.

The CET Boris the Baker owes CDTFA is $27,284 based on the wholesale value of the cookies. The CET is based on the incremental increase in wholesale value [Exit Wholesale Value – Intake Wholesale Value; $220,000 – $106,313 = $113,687] increased by an assumed retail sale mark-up. The mark-up of the incremental increase in value is $181,899 [$113,687 x 1.6 = $181,899]. The CET owed to CDTFA by Boris the Baker based on his incremental addition to the wholesale value of the cannabis product is $27,284 [$181,899 x 15% = $27,284].

Boris the Baker’s gross margin for income tax purposes is $74,867 [$220,000 – $106,313 – $17,000 – $22,000]. Boris the Baker sells the 500 packages of cookies to Doug the Distributor for $272,799 [$220,000 + $52,799 [$25,515 + $27,284] (CET)].

Doug the Distributor incurs $35,000 in additional costs for packaging, labeling and testing the cookies for retail sale. Doug the Distributor sells the cookies to Dismal Dispensary for $365,799 [$295,000 + $70,799 (CET)]. The $70,799 of CET includes $52,799 of CET owed to CDTFA by Ed the Extractor ($25,515) and Boris the Baker ($27,284) plus the additional $18,000 in CET Doug the Distributor owes CDTFA based on his incremental addition of $75,000 to the value of the cannabis material [$75,000 x 1.6 = $115,000 x 15% = $18,000].

Dismal Dispensary advises Doug the Distributor the cookies will be sold at retail for $475,000. Dismal Dispensary’s statement of the amount for which it will sell the cookies raises a question.  Is the CET that Doug the Distributor owes CDTFA determined by Dismal Dispensary’s statement of the retail sale price $475,000 x 15% = $71,250, or is the CET $70,799 [$18,000 from Doug the Distributor’s incremental increase in the value of the cookies plus the $52,799 (CET carried forward)].  Doug the Distributor’s gross margin for income tax purposes is $40,000 [$295,000 – 40,000 – $220,000 = $40,000].

The CET owed to CDTFA by Doug the Distributor will be reduced by the $52,799 [$25,515 + $27,284] which is owed to CDTFA by Ed the Extractor and Boris the Baker, earlier participants in the supply chain leading to the retail level.  Doug the Distributor owes either $18,451 or $18,000 in CET to CDTFA.  The author believes the CDTFA’s answer must be $18,000.  Tax computations cannot be based on the opinions of a retailer of the price at which a product will be sold.  Also, CDTFA’s regulations anticipate adjustments to the assumed 60% retail mark-up.

The preceding presentation of a methodology for the computation, collection and remittance of CET to CDTFA in a real business world model is similar to the incremental value added tax model of the European Union’s Input VAT.  The basic CDTFA model, CA Cannabis Excise Tax – Extraction – Processing, is inadequate for real-world transactions. The utilization this model provides a foundation for addressing other complexities arising from California’s CET regime such as the relationship between the timing of product transfers, payments, tax collection and tax remittance. The critical observation that must be made is that each step in the stream of commerce adds new information, which is dependent on all of the information from each prior step. The authentication, validation, and integrity of the data relating to the movement of cannabis in c-commerce build in an interdependent fashion.  As a consequence, California’s regulated cannabis industry is an ideal candidate for the utilization of BLOCK-CHAIN technology.  California’s regime for the taxation of cannabis coupled with California’s plans relating to the tracking of cannabis demand the implementation of BLOCK-CHAIN technology.

The preceding real business world example of the computation, collection and remittance of Cannabis Excise Tax literally screams “BLOCK-CHAIN”.  The reason the preceding screams BLOCK-CHAIN has NOTHING to do with Bitcoin or another cryptocurrency.  The decentralized transactional recordkeeping, authentication and verification required at each incremental step in the stream of commerce makes BLOCK-CHAIN technology ideal for record-keeping for all aspects of California’s regulation of its cannabis industry.

Author: abizcannabis

Managing Director & CEO of integrated transactional financial advisory, tax, and technology consulting firm - aBIZinaBOX Inc New York, Chicago, and OaklandCPA.CITP.CISM.CGEIT.CGMAExpertise with: Alt. Investments/Private Equity, Real Estate, Professional Services, CA Cannabis, Tech Start-Ups and Distressed Assets/DebtTechnology Certifications including:Advanced & High Complexity Cloud Integrator AICPA PCPS, CAQ,, IMTA, CITP ISACA CGEIT, CISMState CPA Societies in California, Florida, Illinois, New York and TexasExpertise with Regulatory Compliance - US - HIPAA, FINRA, SEC Rule 17(a)(3)/(4), eDiscovery, FINCEN - EU- EBA, ESMA, EIOPA UK - BoE, PRA, FCA