Welcome to Part 2 of our article series about income taxes and income tax provisions within the cannabis industry. If you missed it in the Q2 2023 issue of our CannaQuarterly newsletter, read Part 1: How high should a cannabis company’s gross margin be?

In Part 2, we will explore the total tax expense within a company’s financial statements and how meaningful it is.

Plus: Read to the end for insights on a proposed Accounting Standards Update that would greatly increase cannabis companies’ income tax disclosure requirements. (Or, jump directly to that section.)

IRC Section 280E disallows the deduction of “ordinary and necessary” business expenses for Schedule I and II drugs. Given that cannabis is a Schedule I drug, the only deduction allowed for a cannabis company is cost of goods sold (COGS). This makes a cannabis company’s total tax expense even more important than it might be for a company to which Section 280E does not apply. (For more discussion of Section 280E, see our Part 1 article.)

A company’s total tax expense is the sum of its current tax expense and deferred tax expense. Current tax expense is the tax the company expects to owe to all tax jurisdictions (federal, state, and foreign) for the current period; deferred tax expense is the total change in the company’s total net deferred tax asset or liability from the prior financial statement period to the current financial statement period. Because of the complexities of income tax provisions in general, and the fact that these complexities are exacerbated by Section 280E, we often receive questions from stakeholders asking what a company’s total tax expense means and if there is a way to predict it.

In order to determine this, we downloaded the publicly available 2022 audited financial statements of four large cannabis companies: Cresco Labs Inc., Curaleaf Holdings, Inc., Green Thumb Industries Inc. (GTI), and Trulieve Cannabis Corp.

Current tax expense

In the below chart, we’ve compiled our expected current tax expense for each company using the following assumptions:

• Federal taxable expense should be equal to 21% of the company’s gross profit.
• All entities within the company’s structure are subject to Section 280E.
• No federal benefit of state deduction is allowed under Section 280E.
• The company has a 6% effective blended state tax rate. Several states have recently passed legislation to decouple from Section 280E, but it is not practical to get to the state-level detail based on publicly available information. (See FASB Proposed Accounting Standards Update section below.)

Per the above summary, the current tax expense for Curaleaf, GTI, and Trulieve are all within 15% of expected. Cresco sits just a touch higher at 23.5% variance from expected.

The following are some of the potential reasons for a company’s departure from expected tax due:

• A company must still consider tax rules within the otherwise deductible COGS expenses. It is possible that the company had favorable or unfavorable book-to-tax differences within COGS in prior periods that are reversing, which is resulting in an increase or decreasing result to taxable income within the current period. This is where deferred tax expense comes into play, which we will discuss later in this article.
• We could be over- or underestimating the company’s state blended tax rate at 6%. This information cannot be determined from the publicly available information.
• The number of 280E-decoupled states that a company files in varies. Most cannabis companies operate in what would be a taxable loss if not for 280E. If a company operates in a greater or lesser number of states that conform to or decouple from 280E, their state tax liability can vary significantly.
• The company could have structured their business in a more favorable or unfavorable way. If a company files a consolidated federal tax return, it may “taint” all entities within its structure, resulting in all entities being subject to 280E even if they are not plant-touching.

Ultimately, while it is possible to predict a company’s current tax expense within reason, it is important to note that there are various explanations that could result in material departures. Let’s take a deeper dive into one of the most common: deferred tax expense.

Deferred Tax Expense/(Benefit)

As mentioned above, the company’s total tax expense is composed of its current tax expense and deferred tax expense. There is interplay between the current and deferred tax expense. The deferred tax expense is the change in the company’s net deferred tax asset or liability from the prior period to the current period. Even though cannabis companies have large permanent book-to-tax differences because of Section 280E, deferred tax expense still plays a role in their total tax expense because, for example, temporary book-to-tax differences can arise within a company’s cost of goods sold. As a company’s net deferred tax asset or liability changes, its current tax expense increases or decreases as well.

Deferred tax assets (DTAs) and deferred tax liabilities (DTLs) are generated as a result of temporary book-to-tax differences. When a company generates a DTA, it is generating an asset that will give rise to favorable book-to-tax difference in the future. Conversely, when a company generates a DTL, it is generating a liability that will give rise to an unfavorable book-to-tax difference.

When analyzing its DTAs and DTLs, if a company does not believe that its DTAs will reasonably be used in the future, it is required to offset the DTAs with a valuation allowance (VA). The required netting of various VA buckets can become complicated, but in general a VA is an offset to a net DTA, resulting in $0 deferred being booked for the deferreds that a company does not think it will be able to use in the future.

The current and deferred tax expense are what makes up a company’s total tax expense. The deferred tax expense is booked when a company uses its net DTAs during the year or generates additional net DTLs during the year. Conversely, a deferred tax benefit is booked when a company generates additional DTAs or uses its DTLs during the year.

We have put together the above summary of each company’s deferred tax expense or (benefit), net of change in VA. The above shows that during 2022, all four of the companies that we looked at either generated additional DTAs during the year or used their DTLs, likely resulting in unfavorable book-to-tax differences within their current tax expense.

Summary

• Total tax expense is the sum of a company’s current and deferred tax expense.
• We can try to reasonably predict a cannabis company’s current tax expense by multiplying gross profit by an estimated blended tax rate, but there are factors that will result in departures from the expected current tax expense.
• One of the causes of variance from expected current tax expense is deferred tax expense, which is the usage/generation of deferred tax assets and liabilities.

In order to further understand what drove these companies’ deferred tax benefits, we will need to take a deeper dive into their Deferred Tax Footnotes, which includes a breakout of each of their DTAs and DTLs. We will take a look at these Deferred Tax Footnotes in our Q4 release of CannaQuarterly. (Subscribe now to make sure you don’t miss it.) But in the meantime…

FASB Proposed Accounting Standards Update: Enhanced income tax disclosures

On March 15, the Financial Accounting Standards Board (FASB) issued an exposure draft regarding a proposed Accounting Standards Update that would enhance the detail that a company is required to disclose within its income tax footnote. (An exposure draft is a document published by the FASB to solicit public comment on a proposed new accounting standard.) The following are the highlights from the draft that would have the greatest impact on cannabis companies if adopted by FASB:

• Enhanced disclosure in the rate reconciliation (which will be discussed in a future installment of this article series), including the following categories (as listed in the draft):
  • State and local income tax, net of federal (national) income tax effect
  • Foreign tax effects
  • Enactment of new tax laws
  • Effect of cross-border tax laws
  • Tax credits
  • Valuation allowances
  • Nontaxable or nondeductible items
  • Changes in unrecognized tax benefits
• Separate disclosure would be required for several of the above categories if they make up 5% or more of the company’s expected income tax expense at statutory federal rate.
• For the “state and local” category, a public business entity would need to provide a qualitative description of the state and local jurisdictions that contribute. This would provide detail into each of the states that a company is filing in and would significantly increase visibility into a cannabis company’s state and local filing jurisdictions.
• The amendments proposed would require that all entities disclose the following information about income taxes paid (as listed in the draft):
  • The year-to-date amount of income taxes paid (net of refunds received) disaggregated by federal (national), state, and foreign taxes on both an interim and annual basis
  • The amount of income taxes paid (net of refunds received) disaggregated by individual jurisdictions in which income taxes paid (net of refunds received) is equal to or greater than 5 percent of total income taxes paid (net of refunds received), on an annual basis.

Learn more

The CohnReznick cannabis team is here to help, offering tax, audit, valuation, transaction, and consulting professionals with deep cannabis industry expertise. Contact our team for more information or analysis.

Contact

Michael Harlow, CPA, Partner

301.907.2330

Seth Sherer, Senior Manager

301.280.1962