Missing or Uncollected?
Missing or Uncollected? – Excessive taxes on cannabis is one of several reasons California’s roll-out of cannabis regulation is a fiasco. We have pointed out other reasons, including, an ill-conceived and poorly written amendment to the California constitution, a failure of leadership, bureaucratic ineptitude, and greed. [An excellent discussion of the process by which Proposition 64 evolved from AUMA can be found here]. In this article, we will address solely the responsibility of the California Department of Tax and Fee Administration (“CDTFA”) for the shortfall in the projected tax revenue from cannabis. [See California scales back cannabis tax revenue ]
CDTFA bears both primary responsibility and substantial responsibility for the projected shortfall in the projected tax collections from cannabis! How can such a statement be correct? Isn’t CDTFA either primarily responsible, or substantially responsible, but not both? The lack of conflict between these two statements is readily explained. To the extent cannabis taxes have become due and owing but were not collected, CDTFA bears primary responsibility for the failure to collect. CDTFA is not responsible, however, for those cannabis taxes that did not become due and owing because California was so inept at bringing its underground cannabis industry into a regulated commercial industry. The Bureau of Cannabis Control (“BCC”) and CalCannabis, a Division of the California Department of Food and Agriculture, are the administrative agencies primarily responsible for California’s lack of success in bringing its underground cannabis industry into a regulated commercial marketplace.
This article will address one modest, but very costly, bureaucratic failure. A significant portion of the projected shortfall in tax revenue from the cannabis industry consists of cannabis tax revenue CDTFA failed to collect as distinguished from tax revenue that was never incurred because the business transaction remained part of the underground industry. In this article we will describe five changes CDTFA should make to increase the effectiveness and efficiency with which the two cannabis taxes imposed by Proposition 64 are collected.
The two taxes imposed on cannabis by Proposition 64, Cannabis Cultivation Tax (”CCT”) and Cannabis Excise Tax (“CET”), are unusual taxes. CCT is akin to a severance tax. CET is an excise tax that is “baked into” COGS and collected from the retail consumer. CDTFA failed to adequately analyze the unusual aspects of these two new taxes. CDTFA established processes and procedures for the reporting and remittance of CCT and CET without devoting sufficient study to the differences between other taxes CDTFA collects and these two new taxes. These two new taxes are different from each other as well as from all other taxes administered by CDTFA from the standpoint of imposition, collection, reporting, and remission. Substantial cannabis tax revenues due and owing California for CCT and CET were not collected by CDTFA as a consequence of inadequacies in the processes and procedures established by CDTFA. Some easily made changes will rectify many of these problems.
Missing or Uncollected?
We will first look at CCT. It is the simpler of the two new taxes imposed on cannabis. CCT is imposed on the Cultivator of cannabis. CCT is collected from a Cultivator by a Distributor. The Distributor is required to remit the CCT to CDTFA. Distributors are obligated to collect and pay-over CCT to CDTFA. As a practical matter liability for CCT will invariably be assumed by a Distributor. CDTFA failed to fully analyze the record-keeping and reporting that is required to establish a readily verified record relating to the creation and discharge of liabilities for CCT. Issues relating to the record-keeping required for cannabis taxes will be discussed below because the record-keeping requirements for CCT are comparable to the record-keeping requirements for CET. There are also issues arising from the impact of methods of accounting and the timing of remittances that CDTFA appears to have failed to fully analyze.
As we described above, in most instances cannabis material is sold by a Cultivator to a Distributor who assumes the Cultivator’s CCT liability to CDTFA. The assumption of this liability involves record-keeping and reporting responsibilities which we will discuss below. Based on the language of Proposition 64, and the related legislation, the imposition, collection and remittance of CCT is based on the cash-basis method of accounting. CDTFA appears to have limited its analysis, and consequently its guidance, to a simplistic visualization of transfers of cannabis from a Cultivator and a Distributor.
The cannabis business in California is no longer simple a simple business A Distributor no longer pays a Cultivator in cash and promptly delivers the cannabis to a dispensary for a cash payment. The conduct of business in a regulated cannabis industry ranks among the more complex. The movement of cannabis from Cultivator to consumer should be compared to the many ways in which tomatoes may move from a grower to consumer. In California’s regulated cannabis industry, material moves from a Cultivator to a Consumer through multiple hands usually in multiple transactions involving some extension of credit and in some instances a modification of the material. Taxes must be tracked to the money. Such a tracking necessitates accrual basis accounting. The assumption of a Cultivator’s liability for CCT requires record-keeping reflecting appropriate entries by both the Distributor and the Cultivator. As is described below, the need for accrual basis accounting records is even more critically applicable to CET.
The imposition, reporting, and collection of CET are more complex than CCT. CET is an excise tax imposed on cannabis based on the retail sale price of a cannabis product. CET is imposed as an addition to the retail sale price. The tax is collected from the Consumer at the time of the sale. The dispensary or delivery-only dispensary that sells the product to the Consumer is responsible for computing and collecting this tax. Delivery charges must be included in the sale price for the purpose of computing CET. This wrinkle flows from California’s decision that deliveries must be solely made by the owner of the cannabis product.
Missing or Uncollected?
The CET collected by a dispensary or delivery-only dispensary must be paid over to a Distributor for remittance to CDTFA. A dispensary or delivery-only dispensary that collects CET is holding funds for CDTFA. A dispensary or delivery-only dispensary that collects CET has a fiduciary responsibility with regard to the tax funds collected, although there is no statutory basis for California to assert personal liability against an individual comparable to the liability that can be asserted with respect to with Sales Tax collections. CDTFA has inadequately analyzed record-keeping requirements both with respect to the collection of CET from as well as with respect to the paying over of the CET collected to a Distributor.
It is the failure of CDTFA to specify the financial records that must be prepared and maintained in connection with each transfer of cannabis or cannabis products in California’s commercial cannabis industry that has created major deficiencies in the collection of CCT and CET by CDTFA. CDTFA erroneously failed to require a unique transaction identifier for each transfer of cannabis reflecting both the transfer price for the transaction as well as the associated CCT and CET. CDTFA relied on the tracking of cannabis and failed to require a separate unique transaction identifier.
A functional track and trace system is important for the successful regulation of commercial cannabis industry in California. A separate unique transaction identifier for every commercial cannabis transaction, however, is critical for the collection of CCT and CET. Each commercial cannabis transaction must be recorded with an associated unique transaction identifier that reflects the portion of the total dollars involved in the transaction that consists of CCT or CET. CCT and CET must be separately reflected. Both the transferor and the transferee of the cannabis in every commercial cannabis transaction must be required to prepare and maintain records summarizing all such uniquely identified transactions. Every participant in a commercial cannabis transactions must file CCT and CET tax returns which consists of a summary of all of the uniquely identified transactions in which the licensed cannabis business was involved in the applicable reporting period.
Missing or Uncollected?
The preceding is an explanation of the reasons CDTFA must make the five changes relating to CCT and CET described below. The five required changes are:
CDTFA must require a dispensary or delivery-only dispensary to issue a separate receipt for each sale of cannabis or cannabis products that includes the Cannabis License Number of the seller along with an itemization of each of the taxes collected as part of the retail sale. Further, CDTFA must require each such seller of cannabis or cannabis products to account for, and treat, all taxes collected in connection with such sales as funds held in trust for third-parties. [CCT – CET Responsible Persons]
CDTFA must require every transaction between a Distributor and a dispensary, delivery-only dispensary, Cultivator, manufacturer, or other Distributor to have a unique transaction identifier reflecting the total amount of the transfer price as well as the associated CCT and CET and the party responsible for accounting for, and paying over, the associated CCT and CET to CDTFA. Further, both the transferor and the transferee in any such transactions must file returns of CCT and CET that summarize all of the information required to be included in all uniquely identified cannabis transactions with Distributors. Further, CDTFA must require all Distributors and Manufacturers to prepare and maintain accrual basis financial records.
CDTFA must require every licensed commercial cannabis business involved in the collection of CCT or CET account for, and treat, all funds representing collected CCT or CET as funds held in trust for third-parties.
CDTFA must establish separate, and integrated, tax reporting forms for CCT and CET. CDTFA must also require sufficient related financial information relating to the business activities of Distributors and Manufacturers to accurately reflect the gross revenue, COGS, income, and associated CCT and CET accruals and remittances in order to provide a foundation for ease of verification of accurate reporting of CCT and CET. [See Collecting and Remitting Cannabis Taxes]
CDTFA must require that every licensed commercial cannabis business involved in the collection of CCT or CET to prepare and maintain financial records are based on proper internal financial controls and reconciliations to create readily verified accuracy in connection with the treatment of the funds reflecting tax collections as funds held for a third-party.
We strongly encourage CDTFA to seek legislation that will create a level of personal liability for responsible persons in connection with the failure to properly collect, report and remit CCT and CET. The failure to enact such legislation appears to have left a gap in the ability of California to readily collect taxes it is owed.