California Cannabis M&A Is Challenging As Rules Keep Changing

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AUTHOR:  aBIZinaBOX Inc. CPAs – Jordan S. Zoot, CPA
PUBLISHER:  CANNABIS LAW REPORT

We were prompted to write this note in part by an article published on the Harris Bricken Canna Law Blog entitled, Five Common Problems in California Cannabis M&A Transactions. The article describes five minor, and very obvious, points that must be considered in connection with such a transaction:

(1) California cannabis regulations;

(2) regulatory prohibitions against sales of cannabis licenses;

(3) triggering ownership disclosures through indirect acquisitions;

(4) regulatory prohibition of single-step complete changes of ownership; and

(5) additional considerations for foreign investors.

These five items are issues. These items are obvious considerations for an experienced lawyer representing a party in a significant M&A transaction. We note that it is stunning that no mention is made of the necessity of performing requisite due diligence in connection with an M&A transaction, a discussion that is beyond the scope of this article.

The most significant issues in negotiating and documenting an M&A transaction revolve around the Representations and Warranties. A comprehensive checklist of the issues that should be considered in the preparation of an agreement for a significant M&A transaction will likely be a multi-page document. The checklist is the foundation for the Representations and Warranties which are designed to assure that all of the parties involved in such a transaction receive the benefits for which they negotiated the agreement.

The author has reviewed M&A agreements which were in excess of forty pages of single-spaced type. The author has reviewed M&A agreements for which the attached schedules and exhibits exceeded 250 pages. The critical portions of an M&A agreement involve the scope, survival, and enforceability of the Representations and Warranties as well as a careful delineation of the extent to which each of the parties is obligated.

California’s cannabis industry did not invent M&A activity. Corporate finance and investment and M&A activities have existed from the time business began being conducted through legally recognized artificial business entities. Lawyers have been drafting and litigating M&A agreements for centuries, although most of the significant law for present-day transactions has developed over the past fifty years.

The parties to a significant M&A transaction involving California’s cannabis industry as well as all of their advisors should conduct business based on the premise the arrangements established by the M&A agreement will not evolve in the manner contemplated by the parties at the date the M&A agreement is executed. California’s cannabis industry is changing rapidly. California is struggling with the implementation of a highly regulated legal marketplace for cannabis. This state of flux must be addressed in any M&A transaction documents.

The preceding is simply an explanation of the inspiration for this article, which could be titled more accurately as What Resources Should Be Found in a Cannabis Law Firm? Cannabis law is state-specific with an over-riding gloss of federal law. Federal law covers cannabis law with a suffocating heavy gloss due to the consequences of federal criminal law, the Controlled Substances Act [“CSA”],[1] the Bank Secrecy Act, and IRC §280E. Notwithstanding the focus of most attorneys that provide advice to California’s cannabis industry on these aspects of federal law, some other important bodies of federal law apply to California’s cannabis industry, such as federal securities laws and the RICO statutes. The vaping crisis and the 2018 Farm Bill add other complications at the federal level for advisors. Below the overlay of federal law, cannabis law is state-specific.

Based on the preceding, a cannabis law firm must have state-specific knowledge of cannabis laws as well as access to expertise relating to criminal law, banking law and tax law. Tax law expertise in most instances is best provided through an established relationship of the law firm with a CPA firm in addition to a tax lawyer on board. A CPA firm is generally better equipped to address accounting and reporting issues for a cannabis business than a tax lawyer. The involvement of a qualified CPA firm is required in connection with any significant California cannabis business in order to meet both tax reporting and regulatory reporting requirements.

In connection with any M&A activity involving California cannabis businesses, the expertise of both a tax lawyer and a CPA firm is critical. Taxes payable to a governmental agency represent 45% of every dollar collected from a California cannabis consumer. In an M&A transaction involving a California cannabis business, the Representations and Warranties relating to taxes, the associated indemnifications, and the ability to collect on any indemnification, may prove to be the most important aspects of the agreement.

As an example, consider the likelihood that the accounting firm involved in advising Harborside[2] failed to establish a sufficient reserve for financial accounting purposes through the provision for federal income liabilities because it failed to consider the impact of the two Tax Court decisions as well as the changes in California law relating to cannabis on Harborside’s federal income tax liabilities for 2013-2019[3]. The reserves established may also be inadequate on account of the failure to consider the interest in the assessments for 2007-2012.

The Tax Court Judge in Harborside concluded expert opinions such as the Cost of Goods Sold [“COGS”] report prepared by Henry Levy, CPA were inadmissible. Levy analyzed several regulations, certain sections of the Internal Revenue Code, and some sub-regulatory guidance. Levy concluded that Harborside was entitled to a higher COGS adjustment than it originally claimed. The IRS moved to exclude Levy’s report and testimony on the ground his conclusions were legal opinions rather than facts. Judge Mark V. Holmes agreed, writing in his decision that expert opinions on law are inadmissible because they do not assist the trier of fact. “Each courtroom comes equipped with a ‘legal expert,’ called a judge,” he quipped, citing Burkhart v. Washington Metro. Area Transit Auth., 112 F.3d at 1213.

California is distinctly different from all other states with respect to its cannabis tax law. California tax liabilities that may be open to question after the closing of an M&A transaction involving a California cannabis business may represent as much as 50% of the total consideration paid in the transaction. California enacted two cannabis specific taxes: a Cannabis Cultivation Tax (“CCT”) and a Cannabis Excise Tax (“CET”). These two taxes are different in some respects from all other taxes imposed by California. As a consequence, the administration of these taxes is unusual. California is unlikely to have properly functioning CCT and CET reporting and collection for at least five more years.

California also altered the manner in which the general principles of commercial law apply to cannabis businesses. In addition to taxation, California has enacted specific provisions for some cannabis businesses relating to: water; land use; public health and safety; administrative processes; environmental regulation; trademarks and trade names; unfair competition; California securities laws; local taxation; and local regulation. Advising California cannabis businesses involved in M&A transactions is far more difficult than advising businesses in most industries. The difficulties flow from the necessity of addressing a wide variety of federal, California and local laws and regulations. The complexities in the law, in turn, demand specialized accounting and recordkeeping for financial reporting, tax and regulatory compliance purposes.

The passage of Proposition 64, which was the basis for the legalization of adult-use cannabis in California, preserved all of the rights granted to California residents in Proposition 215, which legalized the medical use of cannabis in California. The differences in the taxation of the movement of cannabis from cultivator to consumer assures that medical cannabis will always be less expensive than adult-use cannabis in California. The differential is sufficiently significant that medical cannabis will exist in California for the foreseeable future. A full understanding of all of the ramifications of the preservation of two forms of legal cannabis in California will take many years to resolve. The differences between adult-use and medical cannabis also make the documentation of M&A transactions more complex.

The California Legislature created a new form of corporation in SB 94[4], a Cannabis Cooperative Association (“CCA”)[5], in order to provide cannabis cultivators with the benefit of the use of agricultural cooperatives as a business structure. This business structure can be utilized solely for the conduct of business by cannabis cultivators. Some of the changes in California’s laws applicable to cannabis businesses as compared to all other businesses flow from the availability of the use of a CCA.

A CCA is a financially more efficient structure for the conduct of business than any conventional business structure, although at this time few appear to have discovered how to effectively utilize this special form of corporation. A CCA is taxed for federal income tax reporting pursuant to Subchapter T of the Internal Revenue Code. In other states, cannabis cultivators may be able to use conventional agricultural cooperatives as operating structures. Any analysis of optimum operating structures, of course, is state-specific.

A cannabis law firm purporting to be able to advise a California cannabis business in a significant M&A transaction, in addition expertise with respect to M&A transactions, and the expertise described above, should at a minimum also have ready access to expertise relating to: environmental regulation; trademark and trade name regulation; unfair competition laws; California and federal securities laws; local taxation; and local regulation. For the reasons described above, extensive experience and expertise with respect to M&A transactions and taxation are likely to be most important. The involvement of a competent CPA firm will also be an absolute necessity.

If anyone told you making money in California’s legal cannabis industry is easy, they lied!

[1] 21 U.S.C. ch. 13 § 801 et seq.

[2] 151 TC 11 or See Tax Court In Harborside

[3] See Cannabis firm Harborside owes $11 million under 280E, US Tax Court rules which fails to note that the interest which will be assessed which likely double the total amount owed. While a substantial savings was achieved through the penalty abatement, penalties will likely be imposed for years after 2012 unless Harborside changed its reporting.

[4] Stats. 2017, Ch. 27, Sec. 107, (Effective June 27, 2017) – Sections 26220-26231.2

 

Sean Hocking

Sean Hocking


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