Newsom and Lawmakers Propose Tax Changes for Beleaguered California Cannabis Industry
Supply Side Reforms Included in Industry Requests and Legislative Proposals
The California cannabis industry is looking for tax relief to help companies buffeted by falling prices and rising costs. Cannabis companies are unable to compete with the lower priced offerings and wider reach of the illegal economy, which by some estimates accounts for two thirds of the cannabis market. While local bans on dispensaries and licensing issues are pushing customers into the illegal market, many in the industry argue that taxes are the main cause of their problems.
Growers are calling for the elimination of both the cultivation tax and the state’s 15% excise tax on cannabis, particularly for “social equity” businesses. Governor Gavin Newsom has included some tax changes in his proposed 2022-23 budget, and state lawmakers have proposed similar measures.
Cannabis Taxation in California
In 2016, voters approved Proposition 64, the Control, Regulate and Tax Adult Use of Marijuana Act, which legalized recreational marijuana use and implemented a 15% excise tax on retail marijuana and a cultivation tax of $9.25 per ounce for flowers and $2.75 per ounce for leaves.
Currently, with inflation adjustments, California charges a cultivation tax of $10.08 per dry-weight ounce for dried cannabis flower, $3.00 per dry-weight ounce for cannabis leaves, and $1.41 per ounce for fresh cannabis plants. Cannabis is also subject to state and local excise taxes paid by licensed marijuana distributors and state and local sales and use taxes paid by retail customers. A May 2022 report from the libertarian Reason Foundation found that, by including local taxes, the effective tax burden on cannabis ranges from $42 to $90 per ounce, exceeding the wholesale production cost of $35 per ounce.
Industry Requests Tax Cut
Some industry representatives wrote Newsom earlier in the year to request elimination of the cultivation tax, a three-year tax holiday of the excise tax, and expanded legal retail access throughout the state. They argued that the “opportunity to create a robust legal market has been squandered as a result of excessive taxation.” This excessive taxation, they argue, “compounds across the supply chain [and] makes our product 50% more expensive at retail than the illicit market.” This price difference “has created an illicit market that is currently three times the size of the legal market” and “threatens the health and safety of medicinal patients and consumers.”
Other industry participants, in a letter to the governor, pointed to a dire situation if taxes are not reduced. “Failure to appropriately reform the industry’s tax structure will create an avalanche of adverse consequences. These losses will include the elimination of thousands of union jobs as businesses close, leaving working class people unemployed; the shuttering of social equity businesses; the continued risk of consumers accessing untested, contaminated products; the proliferation of dangerous cartels; and the lost opportunity to use cannabis tax revenues to subsidize critical services like childcare vouchers, programs for the working poor, and youth harm reduction.”
Proposed Tax Changes
Newsom said he “supports cannabis tax reform and plans to work with the Legislature to make modifications to California’s cannabis tax policy to help stabilize the market.” According to his May Revision to the 2022-23 budget, the state’s “cannabis tax framework is overly complex and burdensome for licensees and consumers.” The budget stated that “[c]urrent tax policies disproportionately burden cannabis farmers, create additional administrative costs and instability throughout the supply chain, and lack sufficient transparency for the state, businesses, and consumers.”
Newsom also noted the difficulty that local restrictions put on the industry. “It is my goal to look at tax policy to stabilize the market,” Newsom said during a news conference. “At the same time, it is also my goal to get these municipalities to wake up to the opportunities to get rid of the illegal market, the illicit market, and provide support in a regulatory framework for the legal market.”
Newsom’s proposed changes include eliminating the cultivation tax beginning July 1, 2022, changing the collection and remittance of the state excise tax from distribution to retail on January 1, 2023, and “strengthening tax enforcement policies to increase tax compliance and collection and reduce unfair competition.”
Proposals in the legislature are similar. SB 1281 would also eliminate the cultivation tax and change the collection and remittance responsibility from distribution to retail but it would go further and reduce the excise tax rate from 15% to 5%. (The provisions would take effect on January 1, 2023.) SB 1074 would repeal the cultivation tax on July 1, 2022, but it would also increase the excise tax rate as needed to make up for the revenue lost by eliminating the cultivation tax.
The budget and legislative proposals closely follow those of the Reason Foundation, which recommended that California repeal or suspend the cultivation tax; reduce the retail excise tax from 15% to 10%; and develop inducements for more local governments to allow cannabis. Elimination of the state cultivation tax is the most likely tax change, but it could still face some resistance, as Proposition 64 requires support of two-thirds of the legislature to change the law.
Federal Tax Challenges
California has recently undertaken initiatives to ameliorate the effects of federal tax restrictions on the cannabis industry. In 2019, Governor Gavin Newsom signed into law AB 37, which rescinds California’s conformity with §280E of the Internal Revenue Code for licensed cannabis sole proprietorships and pass-through entities. Under §280E, cannabis firms that are legal under state law are prohibited from taking business deductions and credits for any trade or business “trafficking” in controlled substances listed under the Controlled Substances Act. This includes marijuana and cannabidiol (CBD) derived from marijuana plants. This prohibition against business deductions requires cannabis companies to base their federal income tax on a modified gross-receipts basis rather than on their net income. This results in federal income tax rates that are significantly higher than similar businesses in other industries. (For a broader discussion of §280E, see Recent Cases Outline Prospects for Change in Taxation and Banking for Medical Marijuana).
By rescinding conformity with the federal law, AB 37 allows state deductions for ordinary and necessary business expenses for cannabis sole proprietors or partnerships for tax years beginning on or after January 1, 2020 and before January 1, 2025. More than simply counteracting the effects of §280E, AB 37 provide some relief for cannabis companies from the state’s franchise taxes and income tax. The law also equalizes the tax treatment of businesses taxed under the state’s personal income tax and those taxed under the corporate income tax, as cannabis businesses taxed as corporations have not been subject to §280E.