Cannabis Tax collections did not meet projections. California has begun to ask why. There are multiple reasons California’s Cannabis Tax collections did not meet projections. One significant reason is the failure of licensed distributors and manufacturers to prepare and maintain appropriate financial records. The California Department of Tax and Fee Administration [“CDTFA”] will begin knocking on doors looking for the taxes that appear to be missing. As a distributor or manufacturer, are you prepared for an audit by CDTFA?
We will offer two Posts which highlight best practices relating to record-keeping and money handling for distributors and manufacturers. We have previously written regarding best practices relating to record-keeping and money handling for dispensaries. This Post addresses best practices relating to Cannabis Cultivation Tax (“CCT”).
From a financial record-keeping and money handling perspective relating to CCT, distributors and manufacturers are virtually identical. The relative costs of cannabis material, CCT and operations for distributors and manufacturers are different, but the financial models for these two types of businesses are essentially the same. It is our impression distributors and manufacturers have been making the same errors and they will have the same problems when audited.
The first error we have frequently seen is the failure of distributors and manufacturers to provide cultivators with a receipt for cannabis material that explicitly states the amount of CCT the purchaser assumes as part of the purchase. Whether such an omission is an error or is deliberate, a cultivator will not be relieved of responsibility to CDTFA for CCT by an inadequate receipt. Distributors and manufacturers, however, accomplish, if anything, with the issuance of inadequate receipts.
Distributors and manufacturers are required by law to collect and pay over CCT. We anticipate in any instance where a distributor or manufacturer lacks an unequivocal record that a cultivator has already paid the CCT, CDTFA will require the distributor or manufacturer to pay the CCT. In an ideal world, a distributor or manufacturer would deposit the CCT into a trust fund account at the time of the acquisition of cannabis material from the cultivator. The world of cannabis distributors and manufacturers, however, is not an ideal world.
The principles we have discussed regarding best practices for dispensaries are equally applicable to distributors and manufacturers. Complete, accurate and verifiable financial records of all financial transactions are critical to the long-term survival of a distributor or manufacturer. A distributor or manufacturer should maintain a trust fund account for CCT, but a distributor or manufacturer is likely to lack sufficient funds to pay the CCT at the time of a purchase of cannabis let alone the ability to place funds in a separate CCT trust fund account. In the absence of a CCT trust fund account, a distributor or manufacturer must have complete, accurate and verifiable financial records with which to convince CDTFA it has paid over all of the CCT it is obligated to pay over.
That a distributor or manufacturer must rely on its complete, accurate and verifiable financial records leads into the second issue relating to the financial record-keeping for CCT. California’s cannabis regulatory agencies bear a significant portion of the responsibility for the creation of this issue. This issue flows in large part from the myopia with which California approached the regulation of its cannabis industry. Cannabis distributors and manufacturers are mid-market businesses. They are distinguishable from other mid-market businesses only in the material that flows through them.
Cannabis flows from the cultivator to consumer through mid-market businesses in the same way that tomatoes flow through mid-market businesses from farmers to consumers. When a product flows from a grower to a consumer, money flows in the other direction – from consumer to grower. CCT is nothing more than a cost imposed by law for the benefit of California on the movement of cannabis from the cultivator to consumer. By law, this cost applies to the cultivator. The collection of this cost is imposed on distributors and manufacturers. The mid-market businesses are required by law to collect and pay over this money to CDTFA.
California took a far too simplistic view of the movement of cannabis through mid-market businesses. California’s regulatory agencies would have done well to study the oil industry or any other industry that has taxes imposed at both ends of the movement of a commodity through a supply chain. California failed to fully comprehend the range of variations that are possible as cannabis moves upstream and money moves downstream from consumer to cultivator. The leaders of California’s cannabis industry share in responsibility because they failed to help California’s regulatory agencies create an efficient and effective system for the collection of CCT.
Cannabis generally but not always comes into the hands of a distributor or manufacturer with CCT already paid or with the distributor or manufacturer assuming the obligation to pay CCT. The CCT associated with cannabis is paid by the distributor or manufacturer or is passed on and assumed by a successor distributor or manufacturer. With complete, accurate and verifiable financial records a distributor or manufacturer establishes who is responsible for paying the CCT associated with each purchase of cannabis to CDTFA. However, unless a distributor or manufacturer has irrefutable evidence that it is not responsible for a CCT liability, the business also must have money on hand to timely pay any CCT liability.
Both California’s cannabis regulatory agencies and the industry overlooked the complexity associated with how business is transacted. The transactions described in the preceding paragraph do not cover all of the possibilities. A distributor or manufacturer may generate revenue from the cannabis industry in other ways. Such a business may also generate revenue that does not involve cannabis. A straightforward example would be a situation in which a manufacturer pays another manufacturer for cannabis extraction services without a transfer of title to the cannabis. A simple variation would be a situation in which a manufacturer generates revenue by performing services in connection with non-cannabis material. The complete, accurate and verifiable financial records a distributor or manufacturer must categorize its sources of revenue. All of the revenue of a distributor or manufacturer may not have an associated CCT.
California’s regulatory agencies are to a substantial degree responsible for the problem described in the preceding paragraph. California’s regulatory agencies have attempted to tie cannabis taxes to the regulation of the cannabis. Financial record-keeping and tax reporting must be tied to the flow of money and not to the flow of commodities. CDTFA should focus on the admonition to “follow the money,” and tax collection will significantly improve.
Please don’t misconstrue our advice to CDTFA to follow this admonition. It is NOT a suggestion to encourage audits of distributors and manufacturers. Audits are generally a waste of time and energy, and therefore a waste of money. It is the threat of an audit that is effective as a deterrent. The threat of an audit, however, is an idle threat without culpable responsibility for reporting. Of greater importance, however, is financial reporting in a tax return that completely and accurately ties all of the revenue and all of the expenses of a cannabis distributor or manufacturer into verifiable financial records.