The cannabis industry is in a state of flux. Because manufacturing and distribution laws vary from country to country, state to state, and in some cases even county to county, cannabis companies—and those they do business with—have to be extremely cautious to ensure compliance and minimize legal and financial risks. In this article, we cover transfer pricing implications unique to the cannabis industry. But first, here’s a brief overview of the current state of the industry and the distinct laws that govern it.
Overview Of The Cannabis Industry Today
Cannabis is considered a Schedule 1 controlled substance, which the U.S. Drug Enforcement Administration (DEA) defines as a drug with high potential for abuse. There is a discord in its treatment at the federal and state level, as it is legal in a number of states (most recently in Illinois) at varying levels, but is illegal at the federal level. While some states have legalized cannabis for medicinal use only, others have legalized it for adult-use as well. Additionally, there are many states where cannabis is still prohibited for both medical and adult uses.
Restrictions & Limitations
Cannabis companies face several growth and financial limitations due to the legal issues at hand. For example, it’s challenging for cannabis companies to expand geographically because they can’t cross state lines with their product due to the federal restrictions. Replicating a business unit in another state where cannabis is legal becomes a challenge because of the restrictive licensing rules, which often require a time period of in state residency before a license will be issued.
Companies in the cannabis industry also have intellectual property issues, because they are not legally allowed to have a federal patent for cannabis or anything related to it. While they can get a patent at the state level, it doesn’t prevent companies in other states from using names, images, or other brand assets that would normally be considered intellectual property under patent law.
Tax Laws & Requirements
Internal Revenue Code Section (IRC) 61(a) requires reporting gross income from whatever source derived, including sources considered illegal at the federal level. Although cannabis companies must report all revenue to the Internal Revenue Service, IRC 280E prohibits the credit or deductions paid or incurred during the taxable year. The government has acknowledged, through a Chief Counsel Advice Memorandum and court decisions that companies subject to IRC 280E can deduct the cost of goods sold (COGS).
Cannabis businesses must follow IRC 471 in determining their COGS, which disallows marketing and advertising costs, selling expenses, research and development costs, interest, and other general and administrative expenses not related to production or manufacturing operations. The amount of expenditures that can be considered COGS depends on whether the cannabis business is considered a ‘reseller’ or ‘producer’ under IRC 471. Resellers are limited to deduction of acquisition costs plus transportation, and other costs incurred to gain possession of inventory. Producers can treat certain direct and indirect costs that are incident and necessary for the production of cannabis as COGS.
Because of these restrictions, cannabis companies are faced with a unique tax burden compared to other businesses. Many of their expenses are disallowed by the federal government; therefore it’s common for cannabis companies to have much higher operating profits—and therefore higher tax rates—than non-cannabis companies, which can deduct all business-related expenses and take advantage of federal tax credits.
Find out if your related-party intercompany agreements are prepared to withstand increased scrutiny by tax authorities.
Transfer Pricing In The Cannabis Industry
While transfer pricing is a focus of tax planning and compliance at an international level, it also is of concern at a state level for specific industries—and cannabis is one of them. Cannabis companies are likely to have entities present in multiple states to expand their market share by creating other cultivation, production, and distribution facilities. Furthermore, due to banking restrictions and risk of property seizures, many cannabis companies have created complex legal structures to obtain bank accounts and to mitigate risk. These related-party transactions must have arm’s length prices in order to comply with transfer pricing guidelines.
Because of the legal issues at play, cannabis companies (and those they do business with) face intense scrutiny from tax authorities. (Tweet this!) To ensure companies are compliant with tax and transfer pricing regulations—and with state and federal laws around controlled substances—government officials want to know everything: what work is being done, which parties and entities are earning profits in which jurisdictions, and many other details.
As such, there is an increasing need for cannabis companies to document everything they do with regard to transfer pricing planning and compliance, including in their intercompany agreements. Intercompany agreements are important for two reasons:
- They provide a paper trail to ensure companies have reasonable rates of return. Because the information in an intercompany agreement ultimately forms the foundation of all intercompany transactions, it’s essential that companies follow contracts verbatim to avoid potential disputes.
- They reduce the risk of legal disputes with tax authorities. Without a clear, written agreement in place, the IRS can determine that both the parent company and entity are trafficking a controlled substance at the federal level.
While having proper documentation won’t guarantee that cannabis companies will have no issues with the tax authorities, transfer pricing studies serve as a benchmark so that if issues arise, companies can substantiate pricing of related-party transactions. As cannabis laws continue to evolve, it will become increasingly important for businesses in the industry to maintain detailed, accurate intercompany agreements and transfer pricing documentation to ensure they’re in compliance with all laws and regulations.
We’ll Help You Comply With Unique Industry Regulation
If your business is in the cannabis industry—or another industry with unique or evolving regulatory guidelines—you need expert guidance to avoid potential disputes and legal issues. Valentiam consultants partner with our clients to ensure compliance while maximizing profits. Let’s talk about your unique business challenges and how we can help solve them.
The Valentiam Group would like to thank Dana Borys, CEO of Dana R. Borys, An Accountancy Corporation, for her invaluable insight as a co-author of this article. Dana specializes in corporate tax services and is a recognized leader in supporting cannabis companies as they navigate their unique set of complex regulatory guidelines.