california Archives - Green Market Report

A few days ago, we published a short note that described how a Cannabis Cooperative Association (“CCA”) could be utilized to circumvent the confiscatory nature of Internal Revenue Code (“IRC”) §280E[i]. Several our readers, including some purported experts, advised us that our suggestion would not work for them because the business organization with which they were involved pre-dated the enabling legislation for CCAs.

Read the law! The California Legislature anticipated this problem. The Legislature was aware many collectives and cooperatives were organized based on Proposition 215 long before a glimmer of hope for legalization even existed in fantasies regarding the future. Beginning even before Proposition 215 was passed, collectives and cooperatives were organized under various provisions of California law for the cultivation and underground distribution of marijuana. Many such groups formed a Nonprofit Mutual Benefit Corporation. Most did little else in the way of the creation of formalizing an organizational structure. There were, of course, some significant exceptions in which a group of individuals established formalized organizations.

Regardless of the extent to which an existing cannabis collective or cooperative has an established legal structure and formal documentation, the California Legislature created an avenue for such organizations to become CCAs. The enabling legislation for CCAs is found in Chapter 22, Title 10, of the Business and Professions Code (“B&P”). Articles 1-10 of Chapter 22 provide the substantive legislation for CCAs. The Legislature included Article 11 to specifically address the issue of existing cannabis collectives and cooperatives that would benefit from a conversion into a CCA[ii].

 

Article 11 provides in relevant part:

“26231. A corporation that is organized or existing pursuant to any law . . . may be brought under the provisions of this chapter by amending its articles of incorporation, in the manner that is prescribed by the general corporation laws, to conform to this chapter. If a corporation amends its articles of incorporation to conform to this chapter, it shall be deemed to be organized and existing pursuant to, and entitled to the benefit of, and subject to this chapter for all purposes and as fully as though it had been originally organized pursuant to this chapter.

“26231.1. Articles of incorporation shall be deemed to conform to this chapter within the meaning of Section 26231 if it clearly appears from the articles of incorporation that the corporation desires to be subject to, and to be organized, exist, and function pursuant to this chapter. [Emphasis added.]

“26231.2. If the amended articles conform, as provided in Section 26231.1, provisions in the articles of incorporation that appeared in the original articles or some previous amended articles, are ineffective if, and to the extent that, they are inapplicable to, or inconsistent with, this chapter.”

It takes far more, of course than an amendment to Articles of Incorporation to convert a collective or cooperative into a duly organized and operating CCA. A CCA that engages in commercial cannabis activity pursuant to the Medical and Adult-Use Cannabis Regulation and Safety Act (“MAUCRSA”) is a special form of corporation expressly created to engage in commercial cannabis activity in California’s cannabis industry through the equivalent of an agricultural cooperative. A CCA is a sophisticated form of an incorporated entity. A CCA is subject to California’s general corporate laws as well as the special provisions of B&P §§26220-26231.2. The combination of these two bodies of law creates operational business advantages for CCAs. The special provisions of law set forth in B&P §§26220-26231.2 trump the general corporate law in the event of a conflict.

A CCA is also subject to special rules for California and federal income tax purposes. A CCA files a return for federal income tax purposes as a cooperative pursuant to Subchapter T[iii]. A CCA files similarly for California income tax purposes. These special filing rules provide income tax advantages for CCAs.

All existing collectives and cooperatives should not be converted into CCAs. Proposition 64 preserved all the rights granted to Californians under Proposition 215. There will be a place in California for unlicensed, unregulated medical collectives for the foreseeable future. The cottage industry of unlicensed, closed-loop collectives is entitled to continue to operate as not-for-profit collectives. Such organizations cannot engage in commercial cannabis activity.

There will also be a place in California for licensed medical collectives and cooperatives for the foreseeable future. Those Proposition 215 collectives and cooperatives that intend to engage in commercial cannabis activity must be licensed. The foundation for a Proposition 215 medical collective is not consistent with commercial cannabis activity. Any such an organization should consider conversion into a CCA. There is no prohibition against a CCA operating as a not-for-profit organization that is engaged in commercial cannabis activity for the benefit of both its cultivator members as well as its consumer members. Any such a collective or cooperative, however it is presently organized, will have a financial advantage over any conventional business structure if the organization properly converts into a CCA.

The special treatment of CCAs for income tax purposes makes these special corporations financially more efficient than conventional business structures for the conduct of cannabis business in California. A CCA also has operational advantages over conventional business structures in connection with the conduct of commercial cannabis activity. The conduct of commercial cannabis activity through a CCA requires experienced legal counsel. Of even greater importance, accounting and tax-reporting advice from a CPA firm are essential to the successful conduct of commercial cannabis activity through a CCA.

A CCA that does nothing more than act as a cooperative marketing representative provides a valuable service for its member growers. In this regard, an organization that acts as a broker must be licensed as a distributor. Marketing representation and sales representation are not the same things, although they are frequently conflated. Licensing is required for representation in connection with sales. The use of a CCA solely for marketing merely scratches the surface of the benefits such an organization can provide with respect to commercial cannabis activity. As we pointed out in the article referenced above, even for a modest cannabis business operation the tax savings that can be secured using a CCA can exceed $1.0M per year.

A CCA that engages in cannabis business activities beyond acting as a cooperative marketing representative, for example operating a wholly-owned cannabis distributor, requires a capable business organization. Such a business operation necessarily requires sophisticated operational and financial record-keeping systems and procedures in order to comply with the regulatory requirements of the California Dept. of Tax and Fee Administration [“CDTFA”] Bureau of Cannabis Control [“BCC”] and other cannabis regulatory agencies as well as the multiple tax filing requirements for California cannabis businesses.

A CCA that operates a wholly-owned cannabis distributor should establish an accrual method of accounting for federal income tax purposes. A number of additional record-keeping benefits, as well as significant tax-saving benefits, will flow from the use of an accrual method of accounting for a CCA engaged in commercial cannabis activity. The establishment of an accrual basis system of accounting for a distributor engaged in business in California’s cannabis industry requires the services of an experienced CPA.

For the gamblers among our readers, the use of a CCA for the conduct of business in California’s cannabis industry is the equivalent of playing with “house” money. For the investors among our readers, the use of a CCA for the conduct of business in California’s cannabis industry is the equivalent of an “all up-side, no down-side” financial arrangement.

Sources & Footnotes

[i] See IRC Sec 280E – Escrows

[ii] See CCA’s Good or Better, California Cannabis Collective the Sky Is Falling and Dead – Alive – Comatose

[iii] IRC Secs. 1381-1383

Corporate Transparency Update. The focus of this website has been on the legal cannabis industry in California. However, many of our clients and regular readers are aware that our practice also focuses on:

• Taxation and Transactional Consulting for pass-thru entities, [limited liability companies [“LLC’s], partnerships and S Corporations
• Alternative Asset and Debt Hedge Funds and Private Equity
• US Title 31 – anti-money laundering [“AML”] provisions and virtual currency
• US Title 26 [“IRC”] – IRS practices and procedures relating to civil and criminal tax controversies

We have written about FinCEN’s Cannabis Industry Policy[1], AML anti-structuring policy[2], and the FDIC’s initial efforts at beneficial ownership, transparency for LLC’s acquiring residential property in major markets[3] and the application to the California cannabis industry[4].

HR 2513 – Corporate Transparency Act

On October 23, 2019, the House passed H.R. 2513. H.R. 2513 is a two-part Bill. Division A is the Corporate Transparency Act, or CTA[5]. If enacted, the CTA would require certain, defined U.S. companies to report identifying information regarding their beneficial owners to the Treasury Department – so that such information would be available to both the government and financial institutions carrying out their own AML duties.

The CTA:

• Requires certain, defined corporations and limited liability companies (see below) to disclose their Beneficial Owners [“BOs”] to FinCEN at the time the company is formed.
• Establishes minimum BO disclosure requirements, including the BOs’ name, date of birth, current address, and driver’s license or non-expired passport number.
• Requires covered companies to file annually with FinCEN a list of its current BOs, and a list of any changes in BOs that occurred during the previous year.
• Imposes civil and criminal penalties for persons who willfully submit false or fraudulent BO information, or who knowingly fail to provide complete or updated BO information.
• The key provision of the CTA is its definition of a “BO.” With certain exceptions, noted below, the CTA broadly defines a “beneficial owner” as a “natural person who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise –”
• exercises substantial control over a corporation or limited liability company;
• owns 25 percent or more of the equity interests of a corporation or limited liability company; or
• receives substantial economic benefits[6] from the assets of a corporation or limited liability company.

At this point, our regular readers should ask why we are writing about federal legislation that is perhaps indirectly related to individuals and entities involved in California’s cannabis industry. The CTA provides for a number of exemptions from the BO disclosure requirements which will be discussed in a separate article.

The CTA will have little direct impact on the owners of “plant touching” cannabis businesses. However, it will have significant application to the owners and purchasers of residential and commercial real estate that may be acquired as an investment of the earning of cannabis industry businesses, which will certainly be exacerbated if the proceeds of cannabis activity originate in the “black market”.

It is also quite possible that the “cash-out” of certain cannabis investments could wind up being invested in real estate or operating businesses that are subject to the CTA.

H.R. 2513 contains another section – “Division B” – entitled the “Counter Act of 2019.” The acronym “COUNTER” stands for “Coordinating Oversight, Upgrading and Innovating Technology, and Examiner Reform.” Division B stretches for 63 pages. It is almost twice as long as the CTA. The COUNTER Act of 2019 represents a grab-bag of detailed provisions relating to BSA/AML reforms which previously had been set forth in a proposed and inelegantly-named bill, “To make reforms to the Federal Bank Secrecy Act and anti-money laundering laws, and for other purposes” (on which we previously blogged, here). The COUNTER Act of 2019 has 35 different sections, including a whistleblower provision; a provision including “dealers in antiquities” in the definition of a “financial institution” covered by the BSA; and many other provisions pertaining to information sharing, resource sharing, and technological innovation.

 

FATF – Best Practices for Beneficial Ownership

The Financial Action Task Force (“FATF”), an international and intergovernmental AML watchdog group, has issued a document entitled “Best Practices on Beneficial Ownership for Legal Persons,” (“Best Practices Guidance”) on November 5, 2019[7] which urges countries to use multiple methods to identify accurately and timely the beneficial owners of legal entities. This document also describes some thoughtful recommendations.

 

The FAFT Best Practices Guidance represents an evaluation of the approaches of the member countries to the collection and maintenance of beneficial ownership information, including specific recommendations. The FATF Guidance identifies six challenges to tracking beneficial ownership[8]

 

Sources Footnotes

[1]See FIN-2014-G001

[2]See Structuring Transactions to Evade and 31 USC 5324,

[3] Much of the initiative in this area was inspired by a series of articles in the New York Times – Anonymous Owner, L.L.C.: Why It Has Become So Easy to Hide in the Housing Market. The issue was discussed extensively in an article in the June 20, 2019 edition of Ballard Spahr LLP’s Money Laundering Watch newsletter – Lawmakers Renew Effort to Overhaul AML Laws, Including Greater Beneficial Ownership Transparency and in Congressional discussion draft of The Improving Laundering Laws and Increasing Comprehensive Information Tracking of Criminal Activity in Shell Holdings [“Illicit Cash”] Act.

[4] Transactions Involving Changes in Ownership, Financial Interests and Entities

[5] The purpose of the CTA is described as,“To ensure that persons who form corporations or limited liability companies in the United States disclose the beneficial owners of those corporations or limited liability companies, in order to prevent wrongdoers from exploiting United States corporations and limited liability companies for criminal gain, to assist law enforcement in detecting, preventing, and punishing terrorism, money laundering, and other misconduct involving United States corporations and limited liability companies, and for other purposes”.

[6] The “substantial economic benefits” prong under the CTA’s definition of a “beneficial owner” represents an expansion of the definition of “beneficial owner” imposed by FinCEN’s existing BO regulation, which contains only the two “control” and “ownership” provisions. How these competing definitions of the same key term can be reconciled is not clear.  It is also not clear is how financial institutions will address checking the beneficial ownership information that they have collected from their customers under the BO regulation against a database that presumably will include different and more expansive information.

[7] FATF previously released its Guidance on Transparency and Beneficial Ownership in October 2014. The earlier FATF Guidance described steps countries should take to prevent the misuse of legal persons for ML/TF. The FATF did not specify the mechanisms that countries should utilize for the collection of beneficial ownership information. Rather FATF described three options for facilitating the cooperation of companies with the competent authorities and ensuring the availability of beneficial ownership information on companies. The three options are:

“Registry Approach – this approach requires company registries to obtain and hold up-to-date information on the companies’ beneficial ownership. This information is made publicly available and would facilitate access by financial institutions, designated non-financial businesses and professions (DNFBPs) and other competent authorities.

Company Approach – under this approach, companies are required to obtain and hold up-to-date information on the companies’ beneficial ownership or companies to take reasonable measures to obtain and hold up-to-date information on the companies’ beneficial ownership.

Existing Information Approach – under this approach, existing BO information is gathered from existing sources, including: (i) information obtained by FIs and/or DNFBPs; (ii) information held by other competent authorities on the legal and BO of companies; (iii) information held by the company as required; and (iv) available information on companies listed on a stock exchange, where disclosure requirements ensure adequate transparency of beneficial ownership.”

[8] The challenges identified were

“Lack of adequate risk assessment concerning the possible misuse of legal persons. Specifically, the mutual evaluation revealed that not all types of legal persons were covered in the risk assessment, relevant risk assessment was not consistent with the results of national risk assessments, and only domestic threats and vulnerabilities associated with legal persons were considered. Finally, FATF concluded that registries, companies, FIs and DNFBPs and competent authorities did not demonstrate a good understanding of the risks involved in using legal persons.

Adequacy, accuracy and timelines of information on beneficial ownership. The evaluation revealed that beneficial ownership information collected was not accurate and there were no systems in place to actively verify, test or monitor the information. Nor were there requirements of legal persons to update their beneficial ownership information or inform the registry that there were changes to beneficial ownership. Countries did not coordinate among different sources of information to cross-check information for accuracy. Moreover, the parties responsible for updating the information lacked rigorous customer due diligence (“CDD”) measures and were unable to identify beneficial ownership information when complex structures or foreign ownership was involved. Finally, there were no record retention requirements.

Access by competent authorities. The evaluation found that there was inadequate mechanism to ensure that competent authorities had timely access to beneficial ownership information. This was so because of the obstacles to information sharing caused by data protection and privacy laws. Moreover, FATF found that competent authorities did not share information and had no procedures to seek information from parties obligated to provide information. The lack of registration and licenses mechanisms caused competent authorities’ difficulty in identifying the source of information. Finally, competent authorities lacked sufficient resources to carry out investigations

Bearer share and nominee shareholder arrangements.  The evaluation determined that countries did not place risk mitigating measures in place to address money laundering concerns, particularly because ownership of the bearer shares and share warrants were not sufficiently accessible or transparent. FATF found that the use of nominee shareholders obscured the ultimate control and ownership of the companies.

Fine and sanctions. The evaluation found that there was generally a lack of effective, proportionate, and dissuasive sanctions directed at companies that failed to provide accurate and up-to-date information on beneficial ownership and reporting entities which failed to apply specific CDD measures required for legal persons. As we previously blogged, many countries in the EU have failed to prosecute people for money laundering offenses and has in general lagged behind the US on enforcement actions against money launderers.

International Cooperation. The evaluation found that there were inadequate mechanisms for monitoring the quality of assistance received from other countries. Specifically requests for information often took a long time to fulfill when they involved multiple international agents and complex legal issues. This concern was amplified by the fact that not all countries keep beneficial ownership information.”