At the end of 2020, the U.S. House of Representatives passed the Marijuana Opportunity Reinvestment and Expungement Act of 2019. This bill is expected to be reintroduced this legislative session. The MORE Act removes marijuana from the list of scheduled substances under the Controlled Substances Act and eliminates criminal penalties for those who manufacture, distribute and possess marijuana. While cannabis legalization is old news in Colorado, changes at the federal level will no doubt have a material impact on Colorado businesses. These changes would likely include the implementation of a new tax.
The good news for the industry is that by removing marijuana from the schedule of controlled substances, Section 280E of the Internal Revenue Code (which disallows deductions for non-inventory expenses such as advertising, retail and selling costs) will no longer burden the industry. However, that tax relief is replaced with a national excise tax on marijuana. Given that state-legal marijuana sales are projected to reach $20 billion in 2023, the cannabis excise tax could generate significant revenue for the federal government. While unlikely, because this reform involves a tax, such a bill could qualify for the budget reconciliation process and could be passed with a simple majority.
The excise tax presented in the MORE Act applies to the producer’s transfer of product to a retailer. The tax is initially based on a percentage of the actual sales price, i.e., the wholesale price, or if there is no wholesale price (for example, for a vertically integrated producer/retailer business), a market price as determined by the Secretary of the Treasury. The tax rate will increase from 5% to 8% during the first five calendar years. However, beginning in the sixth year, the rate would remain at 8% but the tax based would be measured on THC, if THC is measurable in such product, and the prevailing sales price of a gram of THC.
This tax mimics state marijuana excise taxes, such as Colorado’s, which applies a 15% excise tax on producers based on Average Market Rates. Colorado’s AMR is currently set every quarter for seven categories of products: bud, trim, bud allocated for extraction, trim allocated for extraction, immature plant, wet whole plant and seeds. Based on my experience and conversations with clients, marijuana taxes based on THC levels, multiple categories of products and prevailing market rates are difficult to manage from a compliance and enforcement perspective.
The first thing that will make this type of cannabis tax hard to implement is that prevailing sales prices vary widely from state to state and can even vary widely from month to month. It is unclear whether geography and large market fluctuations will be taken into account in setting prevailing prices for purposes of the cannabis excise tax, or if a national price will be determined, or how often the market rates would be determined. Even after interstate commerce is possible, the market will likely vary widely due to difference in local regulations and local cost of production. If a national price is used, businesses may pay excise tax both above and below local prevailing rates. Fairness will be hard to achieve.
“The concept of a THC-based tax makes it clear that Congress has a fundamental misunderstanding of cannabis products.”
Problems with the setting of prevailing market rates were exposed in Colorado when prices dropped 33% between January 2018 and July 2018, and cannabis businesses were forced to pay tax at values well above the price they could actually charge for the product. Colorado initially revised the AMR every six months but later revised its approach to set market rates every quarter. Colorado has also adjusted the excise tax regime to provide that wholesale transfers to third parties are taxed at the price paid, rather than the AMR, which helps those selling wholesale to other marijuana businesses at rates below the AMR and collects more tax from those selling above the AMR. Colorado has also expanded the number of taxing categories from four to seven to reflect market realities. Even so, I have had situations where seven categories is inadequate.
A tax based on THC levels, similar to federal excise taxes for alcohol products, which vary based on alcohol by volume, is a departure from the excise tax regime that has been implemented in most states except Illinois, and now New York, where marijuana products are taxed based on THC content. However, this structure could have unintended consequences, including unnatural impact on demand, if higher tax rates change consumer behavior.
There are several reasons why a tax based on THC levels does not make sense. THC levels are not similar to alcohol levels. More THC does not always mean you will get more “high.” Also, testing accuracy is not uniform or consistent and is subject to manipulation, which will create issues enforcing the cannabis tax. The concept of a THC-based tax makes it clear that Congress has a fundamental misunderstanding of cannabis products.
Many states, including Colorado, impose an additional excise tax on the sale to the customer. Two levels of tax make a regime more complex, but the consumer excise tax is easier to enforce because it is based on actual sales, which are generally easy to verify with accuracy. Massachusetts has implemented the most simple approach to taxing marijuana by applying a single excise tax on the sale to the consumer, based on a percentage of the sales price. This model avoids problems with measuring THC, categorizing products and setting prevailing market rates.
I am hopeful that Congress will take the time to better understand the industry before implementing any marijuana tax based on THC levels or based on a prevailing market rate structure, which tends to frustrate taxpayers when it is disconnected from reality. Both the government and the industry would benefit from a marijuana excise tax that is simple, a characteristic that our federal income tax system certainly lacks. Simplicity would save the industry compliance costs and the government enforcement costs.
— Jennifer Benda is a shareholder at Hall Estill, in its Denver office. She is part of the firm’s tax practice and a former Certified Public Accountant who specializes in advising and defending businesses in the cannabis industry with tax related matters.