What Wrong This Picture
What Wrong This Picture – on February 19, 2019, the California Department of Tax and Fee Administration (“CDTFA”) issued a press release which we have duplicated below. We have duplicated CDTFA’s press release because it suggests to us that CDTFA’s problems with the collection of taxes from the cannabis industry stem from a number of issues in addition to excessive tax rates and the continued existence of a significant underground market. The following is CDTFA’s press release.
“Sacramento – The California Department of Tax and Fee Administration (CDTFA) reported revenue numbers today for cannabis sales for the 4th quarter of 2018. Tax revenue reported by the cannabis industry totaled $103.3 million for 4th quarter returns due by January 31, 2019, which includes state cultivation, excise, and sales taxes. It does not include tax revenue collected by each jurisdiction.
“As of February 14, 2019, California’s cannabis excise tax generated $50.8 million in revenue reported on 4th quarter returns due by January 31, 2019. The cultivation tax generated $16.4 million and the sales tax generated $36.1 million in reported revenue. Retail sales of medicinal cannabis and medicinal cannabis products are exempt from sales and use taxes if the purchaser provides a valid Medical Marijuana Identification card and valid government-issued identification card.
“Previously reported revenue for 3rd quarter returns was revised to $100.8 million, which included $53.3 million in excise tax, $12.6 million in cultivation tax, and $34.9 million in sales tax.
“Revisions to quarterly data are the result of amended and late returns, and other tax return adjustments.
“In November 2016, California voters approved Proposition 64, the Control, Regulate, and Tax Adult Use of Marijuana Act. Beginning on January 1, 2018, two new cannabis taxes went into effect: a cultivation tax on all harvested cannabis that enters the commercial market and a 15 percent excise tax upon purchasers of cannabis and cannabis products. In addition, retail sales of cannabis and cannabis products are subject to state and local sales tax.
“To learn more, visit the Tax Guide for Cannabis Businesses on the CDTFA website.”
If we assume that all of the sales that generated Sales and Use Tax were adult-use sales, the total sales of cannabis and cannabis products would be $412M. If we further assume a little less than 10% of the total sales were medical, we have a reasonable estimate of $450M for the total sales of cannabis and cannabis products for the fourth quarter. If the $450M of retail sales of cannabis and cannabis products included Cannabis Excise Tax (“CET”) in the retail sale amounts, 13.09% is the percentage rate for determining the amount of CET included in the sale price of cannabis. If the preceding analysis is accurate, CDTFA should collect $58.9M in CET in connection with retail sales of cannabis and cannabis products in the fourth quarter.
The $8.6M difference between the CET that CDTFA reported it collected and our estimate of the amount of CET that should be collected from our estimate of total retail sales does not create serious concern for us. There is a lag of approximately 60 days between retail sales and the collection of the associated CET by CDTFA. The timing differences may wholly explain the CET that appears to be missing. Another complication is the manner in which local taxes are taken into account in the computation of Sales and Use Tax as well as in connection with the computation of CET. The fact CDTFA appears to have collected $2.5M less CET in the fourth quarter than it collected in the third quarter is more troubling, but again there are many possible explanations.
An analysis of the meaning of the Cannabis Cultivation Tax (“CCT”) collections reported by CDTFA for the fourth quarter causes us more pause, although our concern may be wholly explained by timing differences. CDTFA’s collections of CCT in the fourth quarter may largely reflect distributor collections of CCT from cultivators in the third quarter that will in large part become retail sales in the first quarter of 2019.
CDTFA reported in the press release quoted above that it collected $16.4M of CCT in the fourth quarter. CCT is part of Cost of Goods Sold (“COGS”) as cannabis moves from the cultivator to consumer. CCT is recovered by each seller of cannabis in the sales price to the buyer of the cannabis as commercial cannabis moves from the cultivator to consumer. The reason CDTFA’s reporting of the collection $16.4M in CCT causes us concern is that the relationship between the CCT associated with a retail sale of cannabis and the retail sale price can vary over a large range. Similarly, the relationship between the CCT associated with a retail sale of cannabis and the CET associated with the same sale can vary over a large range. The CCT that CDTFA has reported it collected in the fourth quarter does not appear to be consistent with the CET that CDTFA collected.
The CET a retail seller of cannabis is supposed to collect from the consumer is 15%. If the CET is included in the sale price, 13.09% of the retail sale price is CET. If timing issues are eliminated, CDTFA should collect from distributors the same amount of CET that retailers collected from consumers. CCT may represent as much as 7%-8% of the retail sale price in the case of a retail sale of flower, although with normal mark-ups we expect CCT to be 4.0%-5.0% of the sale price of the flower. With normal processing costs and mark-ups, CCT is likely to be approximately 1.0% of the retail sale price in the instance of a retail sale of refined oil. The amount of CCT collected by CDTFA in comparison to CET is surprising. This comparison suggests errors or slippage, or perhaps overpayments, of CCT are occurring. There are, of course, many possible explanations.
The CCT collected by CDTFA appears to us to be consistent with the CET that CDTFA reported it collected during the fourth quarter of 2018 if we assume substantially all of the retail sales of cannabis for which CET was collected by CDTFA during the fourth quarter were sales of flower that had been marked-up over the purchase price paid to the cultivator, including CCT, by no more than 70% between the sale by the cultivator and the sale to the retailer. However, these two assumptions are not consistent with the publically reported information of the extent to which oil and edibles have become a significant part of the retail market as well as the extent to which flower appears to have been marked-up as it passed from cultivators to dispensaries during 2018.
CDTFA’s reporting of tax collections from the cannabis industry for the fourth quarter may be accurate. CDTFA’s reporting of such tax collections may be significantly inaccurate. We cannot determine. We are willing to opine that CDTFA has no way of determining whether its tax collections from the cannabis industry are accurate or inaccurate without spending far more money searching for an answer than the answer will be worth. As we have described in other publications, CDTFA can accomplish far more by requiring all of the participants in California’s medical and adult-use cannabis industry to keep financial records that tie CCT and CET to each separate transfer of commercial cannabis in order to facilitate the generation of accurate and readily verifiable CCT and CET tax returns. With such records and such returns, CDTFA will collect the correct amount of tax and each of California’s cannabis businesses will pay the correct amount of tax.