We have discussed in other Posts our concerns about inadequacies in the information the California Department of Tax and Fee Administration [“CDTFA”] has distributed relating to the Cannabis Excise Tax [“CET”] and Cannabis Cultivation Tax [“CCT”] as well as inadequacies in the tax return CDTFA adopted.
We have also regularly submitted questions to CDTFA. Frequently we have suggested answers to our questions.
We are publishing this Post as the foundation for a series of at least three Posts in which we will suggest best practices in the financial record-keeping for cultivators, distributors, and dispensaries.
In this Post we are making suggestions to improve and streamline the tax reporting and collection process for the benefit of CDTFA as well as California’s cannabis industry.
The failure of CDTFA to quickly and accurately make well-reasoned decisions and educate California’s cultivators, dispensaries, manufacturers and distributors of their respective responsibilities concerning the collection, reporting, and remittance of CCT and CET has cost California millions of dollars in lost tax revenue.
The injury that CDTFA has caused does not stop with the cannabis tax dollars California did not collect. CDTFA has caused far more damage with its failure to describe the financial records cannabis businesses must prepare and maintain to prepare accurate and readily verifiable CCT and CET tax returns. This Post will address the financial record-keeping that CDTFA must require to facilitate the preparation of accurate and readily verifiable CCT and CET returns.
Our first suggestion is that CCT and CET belong on separate returns. It is generous to CDTFA to describe its decision to combine CCT and CET in a single report as lacking in thought. The taxes are collected from different taxpayers.
The two taxes are collected at different points in time in the commercial movement of cannabis from cultivator to consumer. The two taxes are payable to CDTFA at different times. CCT is collected from cultivators. CET collection is from consumers. The only characteristic that is shared by CCT and CET is that distributors are responsible for collecting these two taxes and remitting these taxes over to CDTFA. These two taxes are so unrelated that it is possible, perhaps even likely, that many distributors that are responsible for collecting and remitting CET will never remit CCT to CDTFA.
CCT is a “cash basis” tax that distributors and manufacturers are required by law to collect from cultivators at the time cannabis material is transferred. The responsibility for remitting the CCT collected from a cultivator to CDTF is imposed on the manufacturer or distributor that collects this tax. In another Post we have pointed out that the collection and remittance of CCT to CDTFA is one of the “black holes” into which California’s cannabis taxes have disappeared.
We have criticized CDTFA, and we will continue to do so, for its failure to inform and educate cultivators as well as distributors and manufacturers regarding their respective responsibilities relating to the collection and remittance of CCT. Of greater significance, CDTFA failed abysmally to inform and educate the entire group – cultivators, distributors, and manufacturers – regarding the record-keeping responsibilities relating to CCT.
In the unlikely instance in which a cultivator transfers cash funds to a distributor in payment of CCT, the distributor is required to give the cultivator receipt. Such a transaction, of course, is a unicorn. If such a transaction were to occur, CDTFA must demand that the funds be held in a separate trust fund account for the benefit of the State of California. CDTFA must also require the distributor to advise the cultivator when remittance of the funds to CDTFA occurs. The preceding, however, is never going to happen in California’s cannabis industry. Cultivators do not give money to distributors and manufacturers in payment of CCT. In the real world, distributors and manufacturers assume cultivators’ CCT obligation. This is a black hole into which cannabis tax has disappeared. This is also a trap CDTFA created for uniformed cultivators.
The liability for CCT is imposed on a cultivator. Distributors are required to collect CCT from cultivators. A cultivator must receive a receipt from the distributor that expressly identifies the specific amount of CCT the distributor collected from the cultivator in each transaction. Ideally, a distributor would be required to deposit the funds in a segregated trust fund account. California’s cannabis world is not ideal. It is not even close. A cultivator must insist on receiving express and specific documentation from the distributor or manufacturer reflecting the CCT associated with each separate transfer of cannabis. Ideally, a cultivator would also receive a notification from the distributor or manufacturer when its CCT is paid over to CDTFA, but the world of California cannabis is not an ideal world.
CDTFA is responsible for the failure of the State of California to collect the bulk of CCT that was not collected in 2018.
As is described above, a cultivator must receive a receipt or other documentation for CCT in connection with each transfer of cannabis. In order for such a system to work, CDTFA must require that the receipt or other documentation for each transaction involving the collection of CCT have a Unique Tax Transaction Identifier (“UTTI”) that ties the amount of CCT associated with each separate transfer of cannabis to the cannabis transferred. CDTFA must require both parties to each and every transfer of cannabis involving CCT to prepare and maintain financial records that tie each separate transfer of cannabis and the associated amount of CCT to the same UTTI.
If CDTFA requires both parties to each transaction involving CCT to prepare and maintain records tied to a UTTI in the records of both parties, accurate tax returns which reflect the collection and remittance of CCT will result. CCT in effect becomes almost like an inventoried item. The total of all of the CCT collected will be matched to the total amounts remitted, passed-on, or held at any point in time. Verification through an audit is simplified with standardized procedures. However, unless CDTFA requires the use of a UTTI by both parties to every transaction, CDTFA will continue to have a black hole and taxpayers will continue to prepare inaccurate returns.
The collection and remittance of CET involves different but related issues to CCT. The record-keeping issues relating to CET involve a higher level of complexity than those associated with CCT.
However, before we turn to a summary discussion of matters relating to the collection and remittance of CET, we want to mention two peripheral issues.
First, over the next few weeks, we intend to publish discussions of best practices in financial record-keeping for cultivators, manufacturers, distributors, and dispensaries, although not necessarily in that order.
Second, we want to take this opportunity to refer readers to an earlier Post relating to the number of sets of books a California cannabis business must maintain. The reason for this second reference will become evident from the discussion of the collection and remittance of CET that follows.
CET is collected from cannabis consumers. The dispensary or delivery-only dispensary that transfers cannabis to a consumer is required to collect, account for, report and pay-over CET to a distributor. We have separately addressed the responsibilities of the dispensaries that collect CET. In that Post, we emphasized the importance of treating these funds in the hands of the initial collector as trust funds. It is even more critical that a distributor segregate and account for CET as trust funds. A distributor receives CET from a dispensary as money held in trust by the dispensary for the benefit of the State of California. This money is paid over to a distributor as money held in trust. An argument can be easily made that a failure of a distributor to treat this money as funds held in trust is a breach of a fiduciary duty owed to the State of California.
The source of the funds received by a distributor as CET is different from the source of CCT funds. The timing of the obligation to remit these funds to CDTFA is different from the timing for the remittance of CCT. Because the source of the CET and timing for the payment of CET is different for these funds, these funds must be accounted for separately from CCT. Further, these funds must be as separated from any money held by a distributor that represents CCT collected from a cultivator. A distributor that receives both CET and CCT must maintain separate, segregated trust accounts for CET and CCT. For the same reason, a distributor must keep separate sets of financial records for CET and CCT. This is the reason we referenced our Post regarding the number of separate sets of books a cannabis business must maintain.
Like the purchase of cannabis from a cultivator, a sale of cannabis by a distributor must include documentation that explicitly identifies the cannabis sold by the distributor and the associated CET collected by the distributor. The documentation the distributor provides to the purchaser must specifically and expressly identify the cannabis and the associated CET and must be uniquely identified with a UTTI. CDTFA must require both the distributor and the dispensary to utilize a UTTI in connection with each separate transfer of cannabis. CDTFA must also require both parties to prepare and maintain financial records that tie each of the uniquely identified transactions involving CET into the summaries relating to CET reported in their respective tax returns of the dispensary and the distributor.
If CDTFA requires the preparation and maintenance of the records described above, the tracking of CCT and CET will readily follow. Distributors and dispensaries will be able to easily prepare accurate and verifiable tax returns. Distributors will maintain trust accounts which segregate the funds that represent CCT and CET from other funds. Both parties to every transaction involving the collection of CCT or CET will have a unique, separate record of each transfer of cannabis and the associated CCT or CET.
In addition to requiring the use of a UTTI in connection with each transfer of cannabis involving CCT or CET, CDTFA must require each distributor and manufacturer to maintain its books of account for all purposes on an accrual method of accounting. We have written extensively on the mechanics of the accrual method of accounting in “Which Set of Books” and “Cannabis Inventory Costing Update.” The critical elements of the application of the accrual method of accounting to California’s cannabis industry are:
- Revenue recognition must track the movement of cannabis material which must include consideration of commercial shipping terms [eg. FOB Shipping Point and FOB Destination].
- The articles which we have referenced provide the details relating to the procedures for the amounts added to the cost of cannabis material under the specific inventory costing provisions.
- The amounts which are not permitted to be capitalized and included in the cost of cannabis material will be subject to IRC Section 280E or may be deductible under certain circumstances.
The accrual method of accounting will dictate the point at which the earnings process is complete. The use of an accrual method of accounting will also facilitate the determination of cost of goods sold (“COGS”) for each interval as well as the determination of ending inventory.
The calculation of CET using the rules we have suggested that CDTFA require will determine when each transfer of cannabis constitutes a completed sale. The total amount of CET due for each reporting period will be equal to the CET on cannabis goods which are deemed to be sold by the distributor or manufacturer.