Technically speaking… Cannabis Quarterly tax and audit insights, Q1 2022
Cannabis stakeholders have a sometimes dizzying array of regulations to keep track of, brought on by the fragmentation of state markets, federal illegality, and resultant unique considerations when it comes to taxes, accounting, and much more.
Here’s what we’ve been thinking about in Q1 of 2022. Click one of the links below to skip to a specific article.
- Accounting and valuation considerations for cannabis licenses
- State and local tax headaches for a growing cannabis company
- From around the industry: Insights from Davidson & Company LLP
These articles are part of CannaQuarterly, our new quarterly email newsletter for cannabis industry stakeholders, developed by a wide array of CohnReznick specialists plus contributors from around the industry. Subscribe now to make sure you receive future issues, and visit these pages to explore the other articles included in Q1 2022: Perspectives on Growth | Future of Cannabis
Matthew Derba, Monica Peborde, John L. Conover
The legal cannabis industry frontier is blooming. While this may present many opportunities to industry participants, it also comes with its fair share of uncertainty and regulatory and operational challenges – including when determining the fair value of a cannabis license. Entities in the cannabis industry holding or planning to acquire licenses should be aware that there are a number of factors that shape the accounting for and valuation of those licenses.
The financial statement impact is generally driven by how the license was obtained (e.g., acquired from a third party, whether through merger with another company or otherwise, or obtained directly from a state or local government), as well as the estimated useful life of the license. Further, there may be situations when the applicable accounting model requires an entity to measure the fair value of a license, such as when the entity recognizes an intangible asset for a cannabis license acquired in a business combination or the subsequent remeasurement of such an intangible asset in connection with an impairment. Under U.S. Generally Accepted Accounting Principles, intangible assets are non-financial assets that lack physical substance (other than goodwill), such as acquired cannabis licenses.
When performing a valuation of a cannabis license, an entity will consider a number of factors including, but not limited to, the statutory regulations governing such licenses, prevailing industry conditions at the valuation date, and the nature of the license (e.g., whether it enables the licensor to purchase, cultivate, and/or sell cannabis products). These factors could have an impact on the selection of a valuation methodology and on the inputs to the valuation.
Finance teams and accounting departments can get out in front of their entity’s activities and transactions that may give rise to the need for a valuation. A good way of laying the groundwork for doing so is developing and documenting policies and procedures related to the measurement of and accounting for cannabis licenses. The seller of a license should also be aware of the valuation and accounting implications of transferring a license to a third party, as they may be taken into consideration by the buyer, for example, during transaction due diligence.
Further, there are complexities inherent in financial reporting and, possibly, income tax compliance given the unique relationship between accounting and income taxes created by IRC Section 280E. An entity should take care to not underestimate the importance of thinking through the ancillary issues that could arise in connection with the book accounting for a cannabis license intangible.
The following are examples of considerations when determining the accounting treatment for an intangible asset:
- Indefinite vs. finite asset: There is a different accounting model for intangible assets that are amortizable (i.e., finite-lived) than for intangible assets that are not amortized (i.e., indefinite-lived). Accordingly, the impairment assessment is different for finite-lived vs. indefinite-lived intangible assets. For example, assessing whether a finite-lived intangible asset is impaired involves determining whether the carrying value of the asset is recoverable (i.e., assessing whether the projected cash flows generated from the future use and eventual disposal of the asset are expected to be sufficient to recover the recognized value of the asset). There is no such recoverability test when assessing whether an indefinite-lived intangible asset is impaired, in which case an entity compares the fair value of the intangible asset to its carrying value. Determining whether an intangible asset recognized for a cannabis license is indefinite-lived or finite-lived can be a complex issue. Factors such as jurisdiction, type of license, and whether the license is transferable should be carefully considered when making that determination.
- Useful life: If the intangible asset is determined to be finite-lived, then the next step is to determine its estimated useful life, which will impact the amount of current and future amortization. In addition, entities should determine the appropriate financial statement classification of such amortization.
- Internal controls: Developing internal controls to identify impairment for intangible assets is a best practice. These controls should be integrated into existing controls covering impairment considerations for other asset types.
Once policies are developed and documented, entities should regularly assess their adequacy to confirm that they are geared to provide timely and valuable insights that are in accordance with U.S. Generally Accepted Accounting Principles.
When developing policies, entities should also consider whether they will elect the private company alternative to subsume qualifying intangible assets acquired in a business combination into goodwill. If that election is made, the entity must also elect the private company alternative to amortize goodwill.
What does CohnReznick think?
When addressing accounting challenges, entities should take care to understand the full scope and implications of their policy selections. Involving accounting and valuation professionals – particularly ones with experience in an intricate and evolving industry like cannabis – is integral in building out your entity’s policies.
For more insights on cannabis valuation, read our article Cost of capital varies in maturing cannabis market, also available in this issue of CohnReznick’s CannaQuarterly.
Matthew Derba, CPA, Partner
Monica Peborde, CPA, Senior Manager
John L. Conover, CPA, Senior Manager
Like any business expanding into new territories, a cannabis business must keep careful track of the many state and local taxes it will be subject to. But, as is often the case, cannabis’ varying legality can add an extra layer of complexity. Below are some of the top state and local taxation issues to be aware of. In future issues, we’ll explore recent state-specific developments and what they could mean for your business.
The long arms of the states
First, don’t forget that your state tax liability isn’t limited to just states where you are physically present, as states increasingly impose economic nexus rules for both income and sales/use tax. Every state that imposes a sales tax has adopted an economic nexus rule for when an out-of-state business must pay tax, such as if they make more than $100,000 in sales or have 200 separate transactions into that state. From an income tax perspective, licensing intellectual property such as trademarks in the state could trigger an income tax return filing requirement.
Watch out for local taxes
In many states, local taxing jurisdictions require registration and collection of various local sales, gross receipts, or even income taxes. These taxes are in addition to income, sales, and excise taxes at the state level. For example, in Pennsylvania, certain political subdivisions can, and do, impose local income taxes. In California, cities may impose a gross receipts tax, and that city tax rate could be as high as 20% for a cannabis business.
Section 280E conformity
We all know how Internal Revenue Code (IRC) Section 280E negatively impacts a cannabis business for federal income tax purposes. Because most states base their state taxable income on federal taxable income, that negative impact can carry over to the state level as well, with 280E-conforming states also disallowing the deduction of ordinary and necessary business expenses. Still, it’s worth taking a close look at your relevant state laws before counting out that deduction. There has been a trend where, when a state legalizes adult use, it also introduces litigation to decouple from Section 280E; if passed, that legislation typically allows some income tax deductions of ordinary and necessary business expenses at the state level.
Know any special treatments for medical use
While recreational cannabis use is typically subject to standard sales/use tax, the rules vary by state for medical use: Close to 50% of the states exempt medical use, while the other 50% tax it. To make complying even more complex, there are a few states, such as Illinois, that tax medical use at a reduced sales/use tax rate. The reasoning why some states would provide a beneficial treatment for medical use is that under general sales/use tax rules, prescription drugs are exempt from sales/use tax as long as state-specific requirements are met, and the state does not want to penalize patients using cannabis.
When are cannabis purchases subject to sales/use tax?
Sales/use tax is only due on sales to the end consumer. Therefore, items that become part of the finished product sold to the consumer are exempt from sales/use tax if a completed resale certificate is provided to the vendor on a timely basis. In addition, when a state provides a sales/use tax exemption for manufacturing and agriculture equipment, cannabis cultivators and manufacturers should review the state’s rules to determine whether they also qualify for the exemption.
Krista Schipp, Director, State and Local Tax Services
Cannabis north of the border: Shifting consumer preferences and oversupply issues could lead to write-downs and impairment charges
Amid continuing progress in the Canadian cannabis market with regard to product innovation and Cannabis 2.0, companies will need to pay close attention to industry trends and how they may impact their annual financial statements, advisory group Davidson & Company LLP writes. Read article >
The Future of Cannabis
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