The new Agricultural Improvement Act of 2018 (Pub. L. 115-334) (the “Act”) was signed into law by President Trump on December 20, 2018. Much press has been devoted to the fact that the Act generally legalizes industrial hemp and will provide federal Crop Insurance for that crop.

While this is potentially good news for farmers and their bankers, questions remain for bankers about how they can effectively identify a legal hemp crop and distinguish it from an illegal marijuana crop. Although industrial hemp typically looks very different from marijuana grown for recreational consumption, both are derived from the same genetic species: cannabis sativa. Under the Act, the legal difference appears to be based on the THC levels in the processed (or “dry weight”) product.

The Act defines “hemp”  to mean: “the plant Cannabis sativa L. and any part of that plant, including the seeds thereof and all derivatives, extracts, cannabinoids, isomers, acids, salts, and salts of isomers, whether growing or not, with a delta-9 tetrahydrocannabinol concentration of not more than 0.3 percent on a dry weight basis.” Act, §10113.

The revisions to the Federal Insurance Crop Act use that same definition and provide that “hemp” as so defined can be insured under the federal crop program. Act §§11101 and 11119.

Thus, the legality of marijuana under federal law will be determined by whether the THC it contains, by dry weight, is less than 0.3 percent. If the THC level is 0.3 percent or greater, the crop is still subject to the federal Controlled Substance Act as a Schedule 1 drug (similar to heroin).

As the Act goes into effect and federal regulators weigh in on it, banks will need to consider whether they are willing to lend against the legal crop as they would against any other agricultural product, and will also have to examine how they can ensure that the crop against which they are lending has a legally acceptable THC level.

We are starting to work with botanists and others to see how lenders can lend against hemp crops and audit the crop’s compliance with the Act. Certainly, the approach that will be taken by the Federal Crop Insurance Corporation and the Secretary of Agriculture concerning the Corporation’s providing of crop insurance for hemp will be critical for bankers wanting to enter the field.

The U.S. Tax Court’s recent Harborside opinion confirmed what we have warned our clients for quite some time: section 263A is unavailable for any cannabis business that traffics a Schedule I or II controlled substance. This conclusion is consistent with the IRS view espoused in a 2015 IRS Chief Counsel Advice memorandum and the flush language in section 263A, which states taxpayers cannot use section 263A to deduct an otherwise nondeductible item. Many cannabis businesses have relied on section 263A to capitalize expenses that would otherwise be non-deductible under section 280E. Those taxpayers should reconsider their tax return filing positions on not only a go-forward basis, but also for purposes of correcting previously filed returns.

Query: How should cannabis businesses account for their inventories going forward?

There are really two parts to the answer. First, taxpayers should consider the impact of changing their method of accounting for determining cost of goods sold (COGS), and whether it is appropriate to file IRS Form 3115 (Application for Change in Accounting Method) because they adopted a different COGS accounting method. Remember, even an erroneous method of accounting is still a method that usually requires filing that form and sometimes requires IRS permission.

Second, taxpayers should identify and use a permitted method under section 471. Those methods include the following:

Certain Small Businesses (section 471(c))

Taxpayers that are not a tax shelter under section 448(a)(3) and meet the gross receipts test found in section 448(c) may rely on their book method of determining COGS for tax purposes. Stated differently, qualifying taxpayers do not need to make book-to-tax adjustments for COGS. The gross receipts test in section 448(c) generally requires average annual gross receipts for the trailing three tax years not to exceed $25 million. Taxpayers in this category may face little or no impact when they aggressively capitalize costs into COGS for book purposes.

Herd Mentality (Reg. § 1.471-2(a)(1))

Section 471(a) grants broad authority to the IRS to adjust inventories to (1) clearly reflect income and (2) conform to the best practices of the trade or business. The conjunctive “and” requirement is interesting. It suggests that if the industry adopts best practices of capitalizing the majority of direct and indirect costs into COGS, then the IRS cannot adjust the taxpayer’s method solely for the purpose of “clearly reflecting income.” The IRS can only make an adjustment to “clearly reflect income” if it also satisfies the second prong of conforming as nearly as possible to best accounting practices. This suggests that a herd mentality within the industry may limit IRS ability to make COGS adjustments using authority granted to them in section 471.

Inventories at Cost (Reg. § 1.471-3)

Most accountants are familiar with using the inventories at cost method. Taxpayers calculate COGS using the following formula: Beginning inventory + purchases – ending inventory = COGS.

For companies that manufacture the inventory they sell, the formula modifies the purchase component to include: (1) the cost of raw materials and supplies entering into or consumed in the production process, (2) direct labor costs, and (3) indirect production costs incident and necessary for the production of the inventory (not including management expenses, selling costs, or return on capital). As you may suspect, cannabis producers receive a much better result under this method than resellers get.

Lower of Cost or Market (Reg. § 1.471-4)

The lower of cost or market method generally permits taxpayers to write down ending inventory when the carrying or book cost of that inventory is less than its current market value. Such a rule is generally taxpayer favorable because it permits the taxpayer to claim earlier the loss that otherwise arises when the taxpayer eventually sells the inventory. Cannabis businesses should receive a similar benefit. For instance, most markets face declining prices. Using the lower of cost or market method might increase the business’s COGS when production or purchasing costs are higher than the market value of their ending inventory.

Retail Merchants (Reg. § 1.471-8)

The retail method of inventory accounting is the following formula: a “Cost Compliment” multiplied by the retail sales price of goods on hand at the end of the taxable year. The cost compliment is a fraction calculated as (1) the value of beginning inventory plus the cost of goods purchased during the year divided by (2) the retail selling prices of beginning inventory plus the retail selling prices of goods purchased during the year, adjusted for all permanent markups and markdowns. This method is unlikely to produce a very favorable result for most cannabis companies as it does not capitalize indirect costs into COGS. As such, taxpayers would likely be denied deductions for indirect costs under section 280E.

Manufacturers (Reg. § 1.471-11)

This method is the closest method to section 263A and permits capitalization of both direct and indirect production costs — full absorption — to compute COGS. Production costs include direct production costs, as well as fixed and variable indirect production costs. The regulation places indirect costs into one of three buckets: (1) costs that must be included in COGS, (2) costs that are not required to be included in COGS, and (3) costs that are includable in COGS depending on the taxpayer’s book treatment. The word choice in the not required bucket is interesting. It suggests that taxpayers do not face a blanket prohibition of using those costs in COGS, and that taxpayers might in fact be able to capitalize COGS whenever doing so is consistent with industry best practices.

Query: What is the penalty risk for using section 263A?

On December 20, the Tax Court released a subsequent opinion in Harborside that is limited to discussing the application of penalties under section 6662. Harborside avoided penalties because the court determined that they acted reasonably and in good faith. However, it is interesting and noteworthy that the tax years in question were 2007 through 2012. All of those years are prior to the IRS CCA stating the IRS position that cannabis companies cannot rely on section 263A. This suggests that the Tax Court may be less forgiving for tax returns filed after the IRS published the CCA and taxpayers should consider amended returns for open tax years. The Tax Court does provide some insight into penalty relief for tax returns filed after the CCA. They note that the IRS had not promulgated regulations for section 280E, and no such regulations exist today.

The Takeaway

There are significant tax advantages to cannabis businesses that “manufacture” their inventory rather than buying it for resale. As such, cannabis businesses can better position themselves by vertically integrating — typically by producing or processing cannabis — along with retail activities. Tax policy may drive both vertical integration and consolidation within the industry.

The United States has a long history with hemp, legally distinguished from marijuana, but genetically identical as the plant cannabis sativa (L.) — now, hemp is set to reemerge in U.S. agriculture as an important crop following passage of the 2018 Farm Bill expected sometime this week. There had been a lot of speculation, and disappointment, regarding the Bill’s hang up to date — in fact, many had resigned hope of the Bill passing this year at all and already started referring to it as the 2019 Farm Bill. Most people in the agriculture industry are very pleased that the Bill is finally moving forward.

Specific to hemp, people familiar with it as an industrial crop anticipate that the hemp will quickly grow into an important mainstream commodity. Widespread interest in hemp’s chemical derivatives, such as the non-psychoactive substance CBD, is one of the driving factors. Agriculture businesses that have already invested heavily in the industry are thrilled. Although hemp was previously considered an essential crop in the United States dating back to the original 13 colonies and grown by many founding fathers, it has been mostly illegal, except in limited circumstances, since well before the current generation of farmers took over from their own fathers.

Importantly however, it should be noted that although CBD is already big business in the U.S., broader allowances for the production of hemp under the new Farm Bill will not blanket legalize either human or animal consumption of CBD unless any such CBD containing products have specifically obtained approval from the Food and Drug Administration (FDA) under the Food, Drug, and Cosmetics Act (FDCA). Currently only a single substance, Epidiolex, has obtained such approval.

But there’s a lot more to hemp than CBD, such as its more traditional, well-known use as a natural fiber in ropes and textiles. Less well-known, however, may be hemp’s increasing popularity as a composite substrate (fiberglass) or for reinforcing concrete. Increased access and availability of hemp for such purposes will greatly improve research opportunities for other potentially useful applications. Hemp’s inclusion in this year’s Farm Bill signals its widespread shift back to mainstream acceptance over the last decade.

So, ready or not — here comes hemp — or perhaps more accurately, the return of hemp.

Earlier this week the U.S. Tax Court issued its long-awaited opinion for the Harborside case, which addresses several issues that impact cannabis tax planning strategies.  Those issues include:

  • Definition of “consists of” as used in section 280E;
  • A Narrow view of CHAMP and when a business engages in two or more trades or businesses;
  • Hints that separate taxpayers may be aggregated as engaging in separate trades or businesses;
  • Holds that section 263A does not apply to a trafficking business subject to section 280E and must rely on section 471 COGS methodologies; and
  • Interprets the meaning of “produce” for purposes of the COGS method found in Reg. 1.471-11.

The opinion does not discuss whether Harborside is liable for accuracy-related penalties under section 6662(a).  Also, the Tax Court did not adopt the IRS position previously asserted in an IRS Chief Counsel Advice memorandum — that taxpayers must use the section 471 methodologies that existed when Congress enacted section 280E.  We previously questioned that IRS position.

 

We try not to blog about developments outside the scope of our expertise. However, because many of our clients are very involved in Canada (or want to be), we want to share with you this article (authored by a very reputable Canadian law firm) about Ontario’s recently enacted Cannabis License Act and related regulations. Enacted last month, this legislation provides a mechanism for privately-owned business to become licensed retailers in Ontario, though the government-run Ontario Cannabis Retail Corporation remains the exclusive wholesaler and online retailer.  The window for license applications is expected to open December 17.

Headspace v. Podworks: Good News (With Warnings) for Marijuana Trademark Licensors

In January 2017, Headspace International, LLC, a California-based cannabis company, sued Podworks Corp., a Washington-state-based cannabis company, for trademark infringement. Headspace sells a product called “The Clear” and claimed Podworks’ “Top Shelf Clear” product infringed on its trademark. Podworks defended itself by claiming that Headspace did not have valid trademark rights in Washington and that the only use of Headspace’s trademark in the state had been by its in-state licensee, X-Tracted. The trial court in Headspace International LLC v. Podworks Corp., dismissed Headspace’s claim, finding that it had not established trademark rights in Washington. Headspace appealed and on October 29, 2018, the Washington Court of Appeals reversed the trial court’s decision and sided with Headspace.

What Does This Mean for Cannabis Businesses? First, the Good News

  • Lawful use of a trademark in Washington only by a licensee and not by the mark’s owner can support the owner’s state trademark rights, even for cannabis products.
  • A trademark licensor can lawfully exert sufficient quality control to maintain valid trademark rights without violating Washington’s Controlled Substances Act (the “CSA”).
  • A trademark licensor is not necessarily a “true party of interest” under the Washington Administrative Code (WAC).

Digging a Little Deeper

The court cited federal precedent in holding that:

. . . indirect use of a protected mark by a licensee inures to the benefit of the owner of the mark when the owner has sufficient control over the quality of the goods or services provided to customers under the licensed mark” and also that such “use” must be “lawful placement of a mark in the ordinary course of trade.”

The court then had to decide if an out-of-state trademark owner can exert “sufficient control” over the quality of its Washington licensee’s marijuana products without making that licensee’s use of the trademark unlawful under the CSA.

What is necessary to have “sufficient control” over quality? Three factors are assessed, any one of which may support a finding of sufficient control:

  • Contract language authorizing control over the licensee by the licensor,
  • Whether the licensor exercised actual control over the licensee, or
  • Whether the product quality over time was sufficient for the licensor to rely on the licensee to ensure quality control.

Under the CSA (as codified at RCW 69.50.331(1)(b)), licenses to legally produce, process or sell marijuana products may only be issued to in-state entities. Further, license holders may not permit any other entity to use the license (RCW 69.50.325), which the court says bars participation “in the production, processing, or sale” of marijuana products. How can an out-of-state trademark licensor exercise quality control without violating these requirements of the CSA?

Podworks claimed that in order to exercise sufficient quality control over its trademark, Headspace had to unlawfully participate in its licensee’s production or processing of the branded products. If true, this would create a “damned if you do, damned if you don’t” dilemma for Headspace — either it had no enforceable trademark rights because it didn’t exert sufficient control over X-Tracted, or it did exert sufficient control but still had no trademark rights because then X-Tracted’s use of the mark was unlawful. Nevertheless, the court held that sufficient quality control could be exerted “through contractual means” or by relying on the licensee’s own quality control measures, neither of which would violate the CSA, as neither would constitute participation in the production, processing or sale of the branded products.

Podworks then argued that the May 17, 2017 addition to the CSA (RCW 69.50.395), which requires marijuana businesses to disclose all licensing agreements to the WSLCB, should be applied retroactively and thus Headspace’s license to X-Tracted was unlawful, as X-Tracted did not disclose it to the WSLCB when it was entered into in 2014. The court held that X-Tracted’s failure to disclose the Headspace license in 2014 did not make it unlawful, but did note that the WSLCB must now require X-Tracted to disclose the license.

Along With the Good News, Consider These Warnings[1]

  • All current licenses must be disclosed to the Washington State Liquor and Cannabis Board (WSLCB), even those entered into before the disclosure obligation was created in 2017.
  • If a trademark licensor is paid a royalty based on a percentage of its licensee’s profits, said licensor will qualify as a “true party of interest” under the WAC and so must:
    • Be named on the licensee’s marijuana business license,
    • Disclose to the WSLCB the source of funds it invests in the licensee’s business, and
    • Have those funds pre-approved by the WSLCB.

This decision makes clear that licensing agreements will continue to be an effective way for Washington cannabis businesses and out-of-state IP owners to work together to their mutual benefit, but also highlights the significant dangers that can arise from poorly drafted or inappropriately implemented licenses. Creative approaches are required to appropriately compensate licensors without turning them into true parties of interest.  Lane Powell has structured such deals for both licensors and licensees in Washington and other states.

[1] (See WAC 314-55-035, which requires that marijuana licenses “must be issued in the name(s) of the true party(ies) of interest” and then goes on in subsection (1) to define “true parties of interest” as any party that “…has the right to receive, a percentage of the gross or net profit from the licensed business”, and in subsection (5) requires that after licensure true parties of interest “…must continue to disclose the source of funds for all moneys invested in the licensed business. The WSLCB must approve these funds prior to investing them into the business.”)

South Korea is currently garnering a lot of attention in the cannabis industry following its legalization of some cannabis derivatives for medical purposes. The legalization comes as a surprise for many in the international community, particularly because South Korea has aggressively opposed cannabis — most notably by criminalizing the consumption of cannabis by South Koreans traveling abroad to nations where cannabis is legal, such as Canada. Most of Asia, particularly Southeast Asia, has generally lagged behind other regions of the world in cannabis law reform. South Korea’s change of heart is prompting a lot of speculation regarding possible widespread reform across Asia much sooner than previously anticipated.

The revised law adopted November 23, 2018 is limited to CBD concentrates with THC levels too low to cause intoxication. Although somewhat unexpected internationally, it was less surprising for those in South Korea during last year’s media coverage of law enforcement action resulting in the incarceration of an ailing child’s mother for attempting to import CBD derived medication for her 4-year-old son who was suffering from brain cancer — public opinion clearly opposed such punishment. Not long after this event, Shin Chang-Hyun  introduced a legislative amendment to South Korea’s national drug policy — pointing to CBD’s acceptance as an effective treatment related to cancer, autism, dementia and epilepsy in other countries from Europe to North America.

The new rules impose highly restrictive conditions that will apply to the new regime governing the use of medical cannabis. Nevertheless, proponents of legal form for cannabis laws believe the change signals a major shift in attitudes not only by the public generally but more importantly among lawmakers. Additional details regarding implementation of those rules will be available by the end of the year with importation of CBD products anticipated by the middle of 2019.

A public records request by the Salem, OR-based Statesman Journal bore interesting fruit recently in the form of a report by the Oregon Cannabis Commission (OCC) recommending that a single agency regulate cannabis in Oregon. Currently, at least three Oregon regulatory agencies have some degree of oversight affecting the cannabis industry. The Oregon Liquor Control Commission oversees the recreational cannabis market. The Oregon Health Authority regulates the medical marijuana program. The Oregon Department of Agriculture administers the agricultural industry generally and certain food safety programs (as well as the industrial hemp program), which brings it into contact with many producers and processors of cannabis. The OCC, created in 2017 by statutory mandate to make recommendations about the future oversight of cannabis in Oregon, is considering whether Oregon is in need of “a unified and consistent vision on cannabis regulation.”

Some degree of regulatory overlap is likely unavoidable when it comes to cannabis. Cannabis sits in an unusual position in Oregon in that it is either a regulated recreational substance, a quasi-prescription drug, or a statutorily-protected agricultural crop, depending on the context. Indeed, among the states with both medical and adult-use cannabis, Oregon isn’t an outlier. Alaska, California, Colorado, Massachusetts, Nevada and Maine use separate agencies to regulate medical and recreational cannabis, in addition to whichever agencies’ mandates oversee agriculture and food safety (Vermont and Michigan have not yet finalized adult-use regulations).

Washington is the only state with established medical and adult use marijuana programs that has fully consolidated regulation under a single agency, the Washington State Liquor and Cannabis Board (formerly the Washington State Liquor Control Board – Washington has found efficiencies in both regulating marijuana and not reordering stationary). This approach has not been without controversy. Oregon itself has seen similar disputes, some quite recently, as the state’s crowded field of cannabis regulators attempts to rein in the black market trade in Oregon-made marijuana. Striking a balance between patients’ access to medicine, a well-regulated adult use market, and increasing federal scrutiny will likely be an active experiment for years to come.

If the OCC’s draft recommendations are finalized, there’s no certainty as to what form a single Oregon cannabis regulatory agency would take. Extensive statutory changes would be necessary, followed by rule making and transition periods, so it is unlikely that Oregon will see anything more than incremental changes for some years. Even then, cannabis businesses will continue to be overseen by a whole alphabet’s worth of acronyms depending on their activities as employers, taxpayers, farmers, manufacturers, etc. The OCC was supposed to meet on November 27 to discuss and vote on recommendations, but that meeting has been pushed out until at least mid-December. We will post updates as new information becomes available.

Thank you MJBizCon for another great hit last week in Las Vegas!  Previous conferences have consistently provided both valuable and relevant content for attendees. This year was no exception — high quality speakers covering a timely array of topics that ranged from recent developments in production and packaging to strategic considerations for potential partnerships with mainstream companies preparing to enter the cannabis industry. It was a seriously good conference and we encourage all industry participants to attend in the future.

We were happy to send four team members to the event, including three MJBizCon veterans who recently joined our Cannabis Team roster — Josh Ashby, Ben Pirie and Sativa Rasmussen. All four of us welcomed the opportunity to meet with our many clients and industry friends. Apologies to the many other clients (and potential clients) with whom we could not meet for lack of time. We simply had to jump ship in Vegas to head for the 6th Annual Northwest Marijuana Law Conference, hosted by Seattle University School of Law. Sativa and Josh co-chaired the seminar, Lane Powell served as a sponsor, and Justin Hobson and Ben were both speakers. So our absence at the Seattle conference would have been problematic. We have been assured that overlap of the two conferences will be avoided next year. Again, our apologies to the many people whom we wanted to accommodate but could not for lack of time. Of course our phone lines are always open . . . Our goal next year is not only to catch up with our friends and clients but also to facilitate introductions between participants in the industry.

Wishing you all a Happy Thanksgiving,

Josh, Justin, Ben & Sativa

The federal tax reform law that passed in December 2017 included a new incentive, the qualified opportunity zone (QOZ) regime.  The purpose of this tax incentive is to unlock and redirect trillions (yes, trillions) of capital gains into investments into new businesses, and substantial improvements to existing businesses, so long as those businesses are located in a QOZ (generally, designated  low income census tracts from the 2010 census).  The tax world has been abuzz about this enormous opportunity since the IRS issued taxpayer-friendly proposed regulations in late October.  Our summary of the QOZ regime is here, but the basic mechanics are simple: when taxpayers sell appreciated property (e.g., stocks or real estate) they can “roll” the gain into a new investment, with tax benefits for both the original “rolled” gain (deferral and up to 15 percent gain elimination) and the new investment (no tax on future gain).

In our summary, we highlighted the ability to secure QOZ benefits in urban areas, some of which are already attracting investments. QOZ benefits also are available for cannabis-business investments.  There are many QOZs in rural areas that are perfect for grow and processing operations; many urban and suburban QOZs may be good locations for retail outlets and dispensaries.

There are limitations on the types of business that can qualify for QOZ benefits, so no liquor stores, golf courses or sun tan parlors.  But Congress incorporated its “bad business” list from a Code section that has not been changed since 1986.  Accordingly, the “bad business” list does not include cannabis-related activities. (Please don’t ask us to explain why the cannabis industry is punished under one provision of the Tax Code but allowed to take advantage of another provision of the Tax Code; the best we can say is “it’s Congress.”)

So check the map before buying or building. You may find that some locations are more desirable than others, either because it will be easier to raise money from others, save taxes for yourselves, or simply turn out to be a neighborhood in which gentrification occurs more rapidly than normal.