Cannabis In Congress: 'MORE' Is Less But Beware Of The Snake In The 'GRASS'
- The eventual passage of the MORE Act mitigates several operational risks for cannabis businesses that touch the plant.
- The uncertainty around the timing of federal reform measures keeps valuations vulnerable to the impact of 280E as well as ongoing IRS scrutiny.
- The publicly traded Multi-State Operators (MSOs) that generate positive Cash Flow from Operations (which were in our scope), will pay out 50-60% of Cash Flow from Operations (CFO) in taxes. This is a more meaningful metric to consider than an effective tax rate (total tax provision/pre-tax income) because the former excludes the tax effect of non-cash items (e.g. changes in the fair value of biological assets).
- Firms with negative CFO are also liable for income tax payments and, in some cases, continue to accrue large balances. For example, MedMen recently reported its tax liability increased to ~$57M at the end of Q3 because no payments were made in FYE 6/30/20 (nor in its Q1 ending 9/30).
The eventual passage of The MORE Act, removes cannabis from the list of controlled substances and therein mitigates several existing operational risks for cannabis companies. Arguably, Section 280E of the IRS Code is the greatest impediment to free cash flow generation for many plant touching businesses because taxes are based upon gross profit and not net income (and can be on net losses). In addition, it stands to reason that losses incurred by plant touching businesses are ineligible to offset future earnings (NOL Carryforward). Other savings come from the elimination of specific bookkeeping protocols and CPA services related to 280E (as well as accounting for biological assets).
The success of this year’s election (all ballot measures passed to legalize cannabis) coupled with the recent House vote in favor of The MORE Act, further popularizes support to end federal prohibition. While the MORE Act will not advance in the Senate during this session, we believe the House approval sets in motion further consideration by Congress in a Biden Administration.
The MORE Act removes cannabis from the list of controlled substances and mitigates existing operational risks:
IRS Code Section 280E will no longer apply to licensed cannabis businesses. This eliminates costly and complex reporting requirements as well as the potential audit risk of an unfavorable IRS ruling.
Cannabis businesses will be able to maintain bank accounts and no longer be forced to operate in all cash. The added compliance costs are necessary to monitor and reconcile cash movements.
Publicly traded plant touching businesses, such as U.S. MSOs that currently list shares on the CSE will be able to list on major U.S. exchanges such as the NASDQ or NYCE and report financial results in accordance with GAAP. The CSE reporting requirements follow IFRS that includes accounting for biological assets which is complex, costly and in our view a meaningless requirement that adds no value to investors (some of the larger U.S. MSOs have begun reporting under GAAP, because more than 50% of their shareholders are based in the U.S. – more will follow).
The uncertainty around the timing of federal reform measures keeps valuations vulnerable to the impact of 280E. Additionally, the IRS indicates it is stepping up audit efforts of cannabis businesses which could result in additional tax assessments (and penalties). Acquiring entities need to fully understand the potential for further IRS 280E assessments and ensure provisions are in place for indemnification.
Several MSOs have disclosed continued IRS scrutiny and/or issues that remain unresolved due to the evolving interpretations of Section 280E – in some instances, a reserve (contingent liability) remains on the books as a conservative measure in the event of an unfavorable ruling. For our in-depth analysis of MSO tax liabilities, contact us at: email@example.com
Last March, The Treasury Inspector General for the Tax Administration evaluated past IRS examinations of cannabis companies and its overall approach in guiding (educating) these businesses on the complexities of 280E and other related matters. Details of the review are included in its report, The Growth of the Marijuana Industry Warrants Increased Tax Compliance Efforts and Additional Guidance.
Some Multi-State Operators (MSOs) will payout 50-60% of Cash Flow from Operations (CFO) in taxes. This differs from income tax expense stated on the income statement which includes a deferred portion. Due to the complexities of 280E, the varying compositions among cannabis businesses and jurisdictions (types of licenses i.e., fully integrated, retail etc.) and financial reporting requirements (GAAP vs IFRS) the effective tax rate (total tax provision/pretax income) varies significantly among cannabis businesses. Also, cost allocation methodologies can be differ among firms as interpretations of 280E vary. The deferred tax provision that arises (in part) from the changes in fair value of biological assets under IFRS becomes irrelevant under GAAP and eliminates some of the aforementioned variability.
In our view, the effective tax rate (total tax provision/pre-tax income) in not a meaningful metric to assess a firm’s tax burden because it includes the deferred tax effect of non cash items (e.g. changes in the fair value of biological assets). Alternatively, a firm’s current tax provision (the amount that will actually be paid) in relation to CFO are more relevant components in assessing a firm’s liquidity and valuation (See Appendix for a painless tutorial on the components of an income tax provision).
Admittedly, there is not much information to go with given the early stage of the industry’s growth and our scope of review is somewhat limited. For MSO’s with positive CFO (Q3 YTD) , the conclusion we draw is that about half of the cash flow is paid in taxes (NOTE: TerrAscend's current tax provision exceeds the adjusted CFO through Q3 – we understand that this is due to onetime items that have been included in the YTD tax provision and its CFO and that the company expects its tax payout to be more in line with its peers going forward).
Due to the complexities of 280E (as indicated above) and limited operational history, it is very difficult to make comparisons among the MSOs even when considering this alternative framework. Nonetheless,
investors that are not familiar with the financial reporting of income taxes may find this distinction (current vs total provision) relevant in their valuation analysis.
The following chart illustrates the current tax provision (tax due for current period) for MSOs with negative CFO. As shown, the current provision approximates the current income tax payable (in other words, it appears that prior taxes have been paid). This further illustrates that the total tax provision is not relevant when assessing liquidity (in fact, the current provision typically exceeds the total provision. This is due to deferred tax benefits that offset current taxes).
MedMen’s tax liability continues to accrue and has reached ~$57M as of 9/30. Based upon our analysis it appears that the Company has not made payment for income taxes during its FYE 6/30 nor in its Q1 ending 9/30/20.
Income Tax Expense consists of 2 components (note it is the total that appears on the income statement as income tax expense). The component breakdown is found in the footnotes of the financial statements (annually per Form 10K) and if not explicitly indicated in the 10Q (quarterly filings), can be backed into based upon other disclosures (3 variables, 1 unknown).
- Current Portion: Amount owed to or due from the IRS (what is on the tax return. The offset to this on the Balance Sheet is Income Tax Payable (this is classified as a current liability which means its due within one year).
- Deferred Portion: Basically, a theoretical amount of tax due which may or may not come to fruition – for example, the tax impact of a change in fair value of biological assets. This flows to the bottom line but each period as the change in fair value is recorded, the related tax implication is deferred. The offset on the Balance Sheet is Deferred Taxes (which could be an asset or liability – going beyond this would only cause confusion and more drowsiness).
The Controlled Substances Act regulates, among other things, the cultivation, possession and distribution of certain controlled substances, including Cannabis and Marijuana which are illegal under federal law and in many states. This is true whether or not it is possessed for qualifying medical conditions, as provided for in certain state medical marijuana laws or if it is possessed within the few states that permit non-medicinal Adult (Recreational) Use.
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