Existing law, the Medicinal and Adult-Use Cannabis Regulation and Safety Act (MAUCRSA), among other things, consolidates the licensure and regulation of commercial medicinal and adult-use cannabis activities and authorizes persons to conduct specified commercial cannabis activities, as defined, in the state.

The Personal Income Tax Law and the Corporation Tax Law allow various deductions in computing the income that is subject to the taxes imposed by those laws. The Personal Income Tax Law conforms as of a specified date to federal income tax laws with respect to itemized deductions, including business deductions and items not deductible, except as specifically provided. The Corporation Tax Law does not conform to those federal income tax provisions, but specifically provides for deductions for purposes of that law. The Personal Income Tax Law, by conformity to federal income tax laws, disallows a deduction or credit for business expenses of a trade or business whose activities consist of trafficking specified controlled substances, including marijuana.

This bill, for each taxable year beginning on and after January 1, 2019, would specifically provide in the Personal Income Tax Law for nonconformity to that federal law disallowing a deduction or credit for business expenses of a trade or business whose activities consist of trafficking specified controlled substances, only for commercial cannabis activity, as defined under MAUCRSA, by a licensee under MAUCRSA, thus allowing deduction of business expenses paid or incurred during the taxable year in carrying on that commercial cannabis activity under the Personal Income Tax Law.

This bill would take effect immediately as a tax levy.

CONCURRENCE IN SENATE AMENDMENTS

CSA1 Bill Id:AB 37

Author:(Jones-Sawyer)

As Amended Ver:August 30, 2019

Majority vote. Tax Levy

SUMMARY:

Specifies, under the Personal Income Tax (PIT) Law, that the federal disallowance of tax expenditures related to the illegal sale of drugs shall not apply to licensees engaged in commercial cannabis activities in California.

The Senate Amendments:

1. Provide that this bill's provisions apply to taxable years beginning on or after January 1, 2020, and before January 1, 2025.
2. Clarify that this bill's provisions apply to credits as well as deductions.
3. Require the Franchise Tax Board (FTB) to provide specified data in a report to the Legislature on or before July 31 of each calendar year in which either the deductions or credits are allowed.
4. Specify that this report shall be submitted in compliance with Government Code Section 9795.

COMMENTS:

1. An overview of federal law: Under Internal Revenue Code (IRC) Section 280(E), no deduction or credit is allowed for any amount paid or incurred during the taxable year in carrying on a trade or business if such trade or business consists of trafficking in controlled substances prohibited by federal or state law. The federal Controlled Substances Act, in turn, lists cannabis as a Schedule I controlled substance. As a result, a business that sells cannabis is barred from deducting what would otherwise be ordinary and necessary business expenses.
2. An overview of state law: Under state law, the treatment of ordinary and necessary business expenses from commercial cannabis activities differs depending on whether the taxpayer is subject to the PIT Law or the Corporation Tax (CT) Law.
   1. CT Law treatment: For corporations, California has standalone law. As such, the automatic denial of deductions specified by IRC Section 280E does not apply. An entity taxed as a corporation under the CT Law that is involved in commercial cannabis activities is allowed to deduct its ordinary and necessary business expenses, assuming the entity has adequate substantiating records.
   2. PIT Law treatment: The PIT Law, however, conforms to IRC Section 280E. Therefore, California follows the federal treatment of cannabis sales, and disallows a deduction for ordinary and necessary business expenses.
3. This bill: This bill is designed to equalize the treatment of taxpayers subject to the CT Law and the PIT Law by allowing taxpayers subject to the PIT Law to deduct their ordinary and necessary business expenses related to licensed commercial cannabis activities.

According to the Author:

"The cannabis industry has multiple barriers to entry – limited access to banking, compliance with complex state regulations and a high tax burden. In addition to these challenges, the federal government continues to treat our state's legal industry as a criminal activity. Current state law conforms to federal policies that disallow tax deductions for businesses that "traffic" controlled substances, resulting in higher taxes for legal cannabis businesses. Californians voted overwhelmingly to make cannabis a legal enterprise in our state and to benefit from the tax revenue brought in by this new industry. High taxes imposed on legal cannabis products are putting the legal industry at a disadvantage in competing with the illicit market, which results in less tax revenue for the state. AB 37 will ensure that cannabis businesses are taxed like any other legal industry in our state and will help legal businesses thrive in California."

Arguments in Support:

None submitted for current version of this bill.

Arguments in Opposition:

None submitted for current version of this bill.

FISCAL COMMENTS:

According to the Senate Appropriations Committee, the FTB indicates that the revenue loss resulting from this bill is interminable, because it lacks the historical data required to develop a reliable estimate. However, the annual revenue loss resulting from the bill would likely be in the tens of millions of dollars annually (General Fund). FTB's administration costs would be minor and absorbable.

VOTES:

ASM REVENUE AND TAXATION: 10-1-0

YES: Burke, Brough, Chu, Gray, Mayes, Mullin, Petrie-Norris, Quirk, Luz Rivas, Ting

NO: Melendez

ASM APPROPRIATIONS: 17-1-0

YES: Gonzalez, Bloom, Bonta, Brough, Calderon, Carrillo, Chau, Diep, Eggman, Fong, Gabriel, Eduardo Garcia, Maienschein, Obernolte, Petrie-Norris, Quirk, Robert Rivas

NO: Bigelow

ASSEMBLY FLOOR: 69-1-10

YES: Aguiar-Curry, Arambula, Bauer-Kahan, Berman, Bloom, Bonta, Brough, Burke, Calderon, Carrillo, Cervantes, Chau, Chen, Chiu, Chu, Cooper, Cunningham, Dahle, Daly, Diep, Eggman, Flora, Fong, Frazier, Friedman, Gabriel, Gallagher, Cristina Garcia, Gipson, Gloria, Gonzalez, Gray, Grayson, Holden, Irwin, Jones-Sawyer, Kalra, Kamlager-Dove, Lackey, Levine, Limón, Low, Maienschein, Mayes, McCarty, Medina, Mullin, O'Donnell, Obernolte, Patterson, Petrie-Norris, Quirk, Quirk-Silva, Ramos, Reyes, Luz Rivas, Robert Rivas, Rodriguez, Blanca Rubio, Salas, Santiago, Smith, Mark Stone, Ting, Waldron, Weber, Wicks, Wood, Rendon

NO: Melendez

ABS, ABST OR NV: Bigelow, Boerner Horvath, Choi, Cooley, Eduardo Garcia, Kiley, Mathis, Muratsuchi, Nazarian, Voepel

SENATE FLOOR: 33-5-2

YES: Allen, Archuleta, Atkins, Beall, Bradford, Caballero, Chang, Dahle, Dodd, Durazo, Galgiani, Glazer, Lena Gonzalez, Hertzberg, Hill, Hueso, Jones, Leyva, McGuire, Mitchell, Monning, Moorlach, Pan, Portantino, Roth, Rubio, Skinner, Stern, Stone, Umberg, Wieckowski, Wiener, Wilk

NO: Bates, Borgeas, Grove, Morrell, Nielsen

ABS, ABST OR NV: Hurtado, Jackson

UPDATED:

VERSION: August 30, 2019

CONSULTANT: M. David Ruff / REV. & TAX. / (916) 319-2098 FN: 0001815

 THIRD READING  

Bill No: AB 37

Author: Jones-Sawyer (D), et al.

Amended: 8/30/19 in Senate

Vote: 21

SENATE GOVERNANCE & FIN. COMMITTEE: 4-1, 6/12/19

AYES: McGuire, Moorlach, Beall, Wiener

NOES: Nielsen

NO VOTE RECORDED: Hertzberg, Hurtado

SENATE APPROPRIATIONS COMMITTEE: 6-1, 8/30/19

AYES: Portantino, Bradford, Durazo, Hill, Jones, Wieckowski

NOES: Bates

ASSEMBLY FLOOR: 69-1, 5/23/19 - See last page for vote

SUBJECT: Personal income taxes: deductions: business expenses: commercial cannabis activity

SOURCE: California Cannabis Industry Association

DIGEST:

This bill specifies that the federal disallowance of tax expenditures related to the illegal sale of drugs does not apply to businesses engaged in licensed cannabis activities under the state Personal Income Tax (PIT) Law.

ANALYSIS:

Existing federal law:

1. Provides that no deduction or credit shall be allowed for any amount paid or incurred in carrying on a trade or business if such trade or business consists of trafficking in controlled substances, as specified in Internal Revenue Code (IRC) §280E.
2. Prohibits the manufacture, possession, sale, or distribution of marijuana.
3. Classifies marijuana as a "Schedule I" controlled substance under the Controlled Substances Act of 1970. For a drug or other substance to be designated as “Schedule I”, it must be found that the substance "has a high potential for abuse" and has "no currently accepted medical use in treatment in the United States."

Existing state law:

1. Authorizes the consumption of nonmedicinal cannabis by individuals over 21 years of age, referred to as adult-use cannabis, under the Control, Regulate and Tax Adult Use of Marijuana Act of 2016.
2. Consolidates the licensure and regulation of commercial medicinal and adult-use cannabis activities under the Medicinal and Adult-Use Cannabis Regulation and Safety Act (MAUCRSA).
3. Defines "commercial cannabis activity" to include the cultivation, possession, manufacture, distribution, processing, storing, laboratory testing, packaging, labeling, transportation, delivery, or sale of cannabis and cannabis products, as specified.
4. Allows, under both the PIT Law and the Corporation Tax (CT) Law various deductions and credits in computing the income subject to tax.
5. Conforms, as of a specified date, the PIT Law to federal income tax laws with respect to itemized deductions, including business deductions and items not deductible, except as specifically provided.
6. Denies business deductions or credits for cannabis businesses subject to the PIT Law due to conformity with federal tax law, specifically IRC §280E.

This bill:

1. Amends the PIT Law to provide that IRC §280E relating to expenditures in connection with the illegal sale of drugs, shall not apply to the carrying on of any trade or business that is commercial cannabis activity, as defined under MAUCRSA, by a licensee.
2. Applies to taxable years beginning on or after January 1, 2020, and before January 1, 2025.
3. Provides that it is the intent of the Legislature to apply the requirements of Revenue and Taxation Code Section 41 to this bill.

Background

State cannabis law. In 1996, California voters approved Proposition 215, known as the Compassionate Use Act of 1996 (CUA). The Legislature clarified CUA by enacting SB 420 (Vasconcellos, 2003), which established and maintained a voluntary program where qualified patients could be issued Medical Marijuana Identification Cards (identification cards) when deemed appropriate by their attending physician. Qualified patients with identification cards were exempt from criminal liability for possession, transportation, delivery, or cultivation of cannabis.

The cannabis industry remained largely unregulated at the state level until 2015, when the Legislature enacted the Medical Marijuana Regulation and Safety Act (MMRSA). MMRSA comprised a package of legislation that comprehensively regulated many aspects of medicinal use cannabis including cultivation, manufacturing, transportation, distribution, sale, and product safety. In 2016, several bills made slight changes to MMRSA, including renaming MMRSA to the Medical Cannabis Regulation and Safety Act.

On November 8, 2016, California voters approved Proposition 64—the Control, Regulate and Tax Adult Use of Marijuana Act (the Act)—which legalized commercial adult-use cannabis for adults age 21 and older. Less than a year later in June 2017, the Legislature enacted SB 94 (Committee on Budget and Fiscal Review, 2017), which integrated MMRSA with the Act to create MAUCRSA. Among other things, MAUCRSA consolidated the licensure and regulation of both commercial adult-use and medicinal use cannabis activities. It established a system of 20 plus license categories, which includes distributor and retailer, among others.

Cannabis taxes. Proposition 64, and subsequently MAUCRSA, imposes two specific taxes on cannabis: the excise tax and the cultivation tax. A customer who purchases cannabis or cannabis products in the state is subject to the cannabis excise tax, which is equal to 15 percent of the average market price of any cannabis or cannabis products retail sale. The cultivator is subject to the cultivation tax, which applies to all harvested cannabis at the following rates:

• $9.25 per dry-weight ounce of cannabis flower.
• $2.75 per dry-weight ounce of cannabis leaves.
• $1.29 per ounce of fresh cannabis plant.

IRC §280E. In 1981, the U.S. Tax Court heard the case of Edmonson v. Commissioner, in which a drug dealer claimed deductions for cost of goods sold and business expenses, such as mileage, air fare, and packaging costs, among others, on his federal tax return. The Court determined that most of the expenses qualified as ordinary and necessary business expense deductions. In response, Congress enacted the Tax Equity and Fiscal Responsibility Act, which added IRC §280E. This specific section prohibits taxpayers from deducting or claiming credits for any amounts paid or incurred in carrying on any trade or business if such trade or business consists of trafficking in controlled substances. Since cannabis is classified as a Schedule I controlled substance, a business that sells cannabis—even if for medical reasons—cannot claim any tax expenditures for federal tax purposes.

The state’s PIT Law conforms to IRC §280E. Thus, cannabis businesses subject to the PIT—such as a sole proprietorship or a partnership—cannot claim tax expenditures, such as a deduction for ordinary and necessary business expenses, for state tax purposes. IRC §280E will cease to apply to cannabis only when Congress reclassifies the drug at the federal level.

Unlike the state’s PIT Law, the state’s CT Law is standalone law, which means the automatic denial of tax expenditures specified by IRC §280E does not apply for state tax purposes. This allows cannabis businesses subject to CT Law, such as Corporations, to claim state tax expenditures despite cannabis’s classification at the federal level.

California does have an additional law that further denies deductions—such as the cost of goods sold deduction—for income derived by a taxpayer from specified illegal activities. This applies to taxpayers under either the PIT or the CT. However, the law only applies if the taxpayer was determined to be engaged in criminal profiteering, including drug trafficking, and found to be engaged in these activities through a final determination in a criminal proceeding (AB 1369, Gatto, 2011).

AB 1863 (2018). In 2018, the Legislature passed AB 1863, which was substantially similar to AB 37. However, the Governor vetoed the measure.

Section 41. In 2014, Governor Brown signed SB 1335 (Leno, 2014), which added Section 41 to the Revenue and Taxation Code.  In the hopes of applying  the same level of review used for government spending programs to tax expenditure programs, including tax credits, Section 41 requires any bill introduced on or after January 1, 2015, that allows a new income tax credit to contain specific goals, purposes, and objectives that the tax credit will achieve.  In addition, Section 41 requires detailed performance indicators for the Legislature to use when measuring whether the tax credit meets its goals, purposes, and objectives.  This year, the Assembly Revenue and Taxation Committee adopted a new policy, requiring that all new tax expenditure proposals including sales and use tax exemptions, comply with Section 41’s requirements. 

FISCAL EFFECT: Appropriation: No Fiscal Com.: Yes Local: No

According to the Senate Appropriations Committee, the Franchise Tax Board (FTB) indicates that the revenue loss resulting from this bill is interminable, because it lacks the historical data required to develop a reliable estimate. However, the annual revenue loss resulting from the bill would likely be in the tens of millions of dollars annually (General Fund). FTB’s administration costs would be minor and absorbable.

SUPPORT: (Verified 8/28/19)

California Cannabis Industry Association (source)

California Asian Pacific Chamber of Commerce

California State Treasurer Fiona Ma

CMG/Caliva

Conference of California Bar Associations

Eric Garcetti, Mayor of Los Angeles

Humboldt County Growers Alliance

Independent California

Osiris Ventures, dba NorCal Cannabis

Rural County Representatives of California

Southern California Coalition

United Cannabis Business Association

OPPOSITION: (Verified 8/28/19)

California Narcotic Officers Association

ARGUMENTS IN SUPPORT: According to the author, “The cannabis industry has multiple barriers to entry – limited access to banking, compliance with complex state regulations and a high tax burden. In addition to these challenges, the federal government continues to treat our state's legal industry as a criminal activity. Current state law conforms to federal policies that disallow tax deductions for businesses that "traffic" controlled substances, resulting in higher taxes for legal cannabis businesses. Californians voted overwhelmingly to make cannabis a legal enterprise in our state and to benefit from the tax revenue brought in by this new industry. High taxes imposed on legal cannabis products are putting the legal industry at a disadvantage in competing with the illicit market, which results in less tax revenue for the state. AB 37 will ensure that cannabis businesses are taxed like any other legal industry in our state and will help legal businesses thrive in California.”

ARGUMENTS IN OPPOSITION: According to the author, “The bill will result in significant General Fund revenue loss to the State of California and we must respectfully oppose it. California has significant problems of illicit marijuana commercial activity. The California Narcotic Officers Association believes that rather than reduce California’s General Fund revenues related to the legal marijuana industry, the amount that would be lost by AB 37 should be used for enforcement activity aimed at reducing the illicit marijuana industry.”

ASSEMBLY FLOOR: 69-1, 5/23/19

AYES: Aguiar-Curry, Arambula, Bauer-Kahan, Berman, Bloom, Bonta, Brough, Burke, Calderon, Carrillo, Cervantes, Chau, Chen, Chiu, Chu, Cooper, Cunningham, Dahle, Daly, Diep, Eggman, Flora, Fong, Frazier, Friedman, Gabriel, Gallagher, Cristina Garcia, Gipson, Gloria, Gonzalez, Gray, Grayson, Holden, Irwin, Jones-Sawyer, Kalra, Kamlager-Dove, Lackey, Levine, Limón, Low, Maienschein, Mayes, McCarty, Medina, Mullin, Obernolte, O'Donnell, Patterson, Petrie-Norris, Quirk, Quirk-Silva, Ramos, Reyes, Luz Rivas, Robert Rivas, Rodriguez, Blanca Rubio, Salas, Santiago, Smith, Mark Stone, Ting, Waldron, Weber, Wicks, Wood, Rendon

NOES: Melendez

NO VOTE RECORDED: Bigelow, Boerner Horvath, Choi, Cooley, Eduardo Garcia, Kiley, Mathis, Muratsuchi, Nazarian, Voepel

Prepared by: Marnie Brown / GOV. & F. / (916) 651-4119

9/3/19 10:58:37

**** END ****

3SENATE COMMITTEE ON APPROPRIATIONS

Senator Anthony Portantino, Chair

2019 - 2020 Regular Session

AB 37 (Jones-Sawyer) - Personal income taxes: deductions: business expenses: commercial cannabis activity

Bill Summary:

AB 37 would specify that the federal disallowance of tax expenditures related to the illegal sale of drugs would not apply for businesses engaged in licensed cannabis activities.

*********** ANALYSIS ADDENDUM – SUSPENSE FILE ***********

The following information is revised to reflect amendments

adopted by the committee on August 30, 2019

Fiscal Impact:

The Franchise Tax Board (FTB) indicates that the revenue loss resulting from this bill is interminable, because it lacks the historical data required to develop a reliable estimate. However, the annual revenue loss resulting from the bill would likely be in the tens of millions of dollars annually (General Fund). FTB’s administration costs would be minor and absorbable.

Author Amendments:

Make technical changes and codify the requirement that FTB to report annually to the Legislature regarding usage of the credits and deductions allowed by the bill.

-- END --

SENATE COMMITTEE ON APPROPRIATIONS

Senator Anthony Portantino, Chair

2019 - 2020 Regular Session

AB 37 (Jones-Sawyer) - Personal income taxes: deductions: business expenses: commercial cannabis activity

Bill Summary:

AB 37 would specify that the federal disallowance of tax expenditures related to the illegal sale of drugs would not apply for businesses engaged in licensed cannabis activities.

Fiscal Impact:

The Franchise Tax Board (FTB) indicates that the revenue loss resulting from this bill is interminable, because it lacks the historical data required to develop a reliable estimate. However, the annual revenue loss resulting from the bill would likely be in the tens of millions of dollars annually (General Fund, see Staff Comments). FTB’s administration costs have yet to be identified.

Background:

Tax expenditure programs (TEPs) are special tax provisions that reduce the amount of revenues the “basic” tax system would otherwise generate in order to provide (1) benefits to certain groups of taxpayers, and/or (2) incentives to encourage certain types of behavior and activities, such as charitable giving. Specifically, current law provides for, among other things, various income and corporation tax credits and deductions, as well as exemptions from the sales and use tax. The Department of Finance is required to publish a list of TEPs (currently totaling several hundred), which currently total $65 billion annually

Federal law prohibits the manufacture, possession, sale, or distribution of cannabis, which is listed as a Schedule I controlled substance under the Controlled Substances Act (CSA). However, in 1996, California voters approved Proposition 215, known as the Compassionate Use Act of 1996 (CUA). CUA allowed qualified patients and primary caregivers to obtain and use medical cannabis. The Legislature clarified CUA by enacting SB 420 (Vasconcellos, 2003), which exempted qualified patients and caregivers from prosecution for using, or collectively or cooperatively cultivating medical cannabis, and established a medical cannabis card program for patients to use on a voluntary basis. SB 420 provides a safe harbor for qualified patients regarding the amount of cannabis they may possess and the number of plants they may maintain. It also protects patients with valid identification cards from both arrest and criminal liability for possession, transportation, delivery, or cultivation of cannabis.

In 2015, the Legislature enacted the Medical Marijuana Regulation and Safety Act (MMRSA), a package of legislation that comprehensively regulates many aspects of medical cannabis including cultivation, manufacturing, transportation, distribution, sale, and product safety. In 2016, several bills made slight changes to the MMRSA, including renaming the Act the Medical Cannabis Regulation and Safety Act (MCRSA). Among other provisions, MCRSA creates the Bureau of Medical Cannabis Regulation (the Bureau) within the Department of Consumer Affairs to oversee and enforce the state’s medical cannabis regulations in collaboration with the Board of Equalization (BOE), the California Department of Public Health, and the California Department of Food and Agriculture (CDFA).

In November, 2016, California voters approved the Control, Regulate and Tax Adult Use of Marijuana Act (Act), which legalized the recreation use of cannabis by adults age 21 and older (Proposition 64). The initiative establishes 19 different license categories, including many established by the MCRSA. However, licenses for adult cannabis use facilities are distinct from those for medical facilities issued under MCRSA.

Additionally, the Legislature recently repealed the MCRSA, but included many of its provisions into the new Medicinal and Adult-Use Cannabis Regulation and Safety Act, and renamed the Bureau as the Bureau of Cannabis Control (SB 94, Committee on Budget and Fiscal Review, 2017). SB 94 seeks to establish a single system of administration for cannabis laws in California to reflect the enactment of Proposition 64.

Existing federal and state law provides that all income, from whatever source derived, is included in a taxpayer's gross income, including income obtained from illegal business activities, actual crimes, or unethical or immoral business practices. State and federal law generally allow business taxpayers to deduct from income any ordinary and necessary business expenses.

Current federal law (IRC §280E) prohibits a taxpayer from deducting or claiming a credit for any amount paid or incurred in carrying on any trade or business if such trade or business consists of trafficking in controlled substances within the meaning of Schedule I and II of the CSA. California’s personal income tax (PIT) conforms to federal law, but not the Corporation Tax. California has additional law that further denies deductions for personal income and corporation taxpayers that are directly derived from illegal activities, including for costs of goods sold, but only if the taxpayer was determined to be engaged in criminal profiteering, including drug trafficking (AB 1369, Gatto, 2011). However, the law expressly states that a taxpayer must be found to be engaged in these activities through a final determination in a criminal proceeding, or a proceeding in which the state, county, city or other political subdivision was a party.

Consequently, a business that sells marijuana, even if for medical reasons, cannot deduct ordinary and necessary business expenses from federal tax like a normal business, and can only do so for state purposes if the firm is a corporation. Instead, the marijuana business pays state and federal taxes based on their income for federal purposes, but can claim a deduction for the costs of goods sold. IRC §280E will only cease to apply to cannabis businesses if and when Congress changes the classification of cannabis to no longer be classified as a Schedule I or Schedule II controlled substance.

Proposed Law:

This bill would, for taxable years 2020 through 2024, specify the federal disallowance of tax expenditures related to the illegal sale of drugs shall not apply to licensees engaged in commercial cannabis activities subject to the PIT. By doing so, the bill would decoupls the state’s PIT from IRC §280E. Additionally, it would task FTB with specified data collection and reporting requirements.

Related Legislation:

AB 1863 (Jones-Sawyer, 2018) and AB 420 (Wood, 2017), both contained provisions substantially similar to this bill. AB 420 was held under submission on the Suspense File of this Committee. AB 1863 was vetoed by the Governor.

Staff Comments:

FTB research staff identified a review article issued by the University of California Agricultural Issues Centers (AIC) that examined six different studies on the cannabis market and its potential market size. The AIC review article indicated that the retail cannabis market in the State could be valued between $4 and $11 billion. FTB assumes that applicable business expenses are 20 percent of sales; thus, every $1 billion in retail sales would result in an additional $200 million in deductions. Moreover, at a six percent tax rate, the revenue loss would be $13 million per $1 billion of retail sales. Because the size of the cannabis market is unknown, the revenue loss resulting from this this bill is indeterminable, but likely in the tens of millions of dollars annually.

Additionally, FTB notes that in addition to expense deductions, this bill would allow commercial cannabis activities to claim tax credits. Because the amount and types of credits these business would claim is unknown, the additional revenue loss attributable to credits is unknown.

-- END --

SENATE COMMITTEE ON GOVERNANCE AND FINANCE

Senator Mike McGuire, Chair

2019 - 2020 Regular

Personal income taxes: deductions: business expenses: commercial cannabis activity

Specifies that the federal disallowance of tax expenditures related to the illegal sale of drugs does not apply under state Personal Income Tax for businesses engaged in licensed cannabis activities.

Background

Tax expenditures. California law allows various income tax credits, deductions, exemptions, and exclusions. The Legislature enacts such tax incentives either to compensate taxpayers for incurring certain expenses, such as child adoption, or to influence certain behavior, such as charitable giving. The Legislature uses tax incentives to encourage taxpayers to do something that but for the tax credit, they would otherwise not do. The Department of Finance is required annually to publish a list of state tax expenditures, currently totaling around $65.2 billion per year.

Unlike deductions, which reduce the amount of earnings subject to tax, credits are applied after taxable income is calculated. Tax credits reduce—dollar for dollar—the amount of taxes owed.

Federal law relating to cannabis. Federal law prohibits the manufacture, possession, sale, or distribution of cannabis. In 1970, Congress enacted the Controlled Substances Act (CSA), which sets forth five schedules of specified drugs. For a drug to be designated a Schedule I controlled substance, CSA states the substance must have “a high potential for abuse," and have "no currently accepted medical use” in the United States. Federal law lists cannabis as a Schedule I controlled substance.

State law relating to cannabis. In 1996, California voters approved Proposition 215, known as the Compassionate Use Act of 1996 (CUA). Under CUA, qualified patients with specified illnesses—and their primary caregivers—cannot be prosecuted for possessing or cultivating cannabis upon the written or oral recommendation or approval of an attending physician. In other words, CUA allowed qualified patients and primary caregivers to obtain cannabis for medicinal use.

The Legislature clarified CUA by enacting SB 420 (Vasconcellos, 2003), which established and maintained a voluntary program where qualified patients could be issued Medical Marijuana Identification Cards (identification cards) when deemed appropriate by their attending physician. Qualified patients with identification cards were exempt from criminal liability for possession, transportation, delivery, or cultivation of cannabis. SB 420 directed the Department of Public Health to administer the program and required county health departments to issue identification cards to patients and primary caregivers who voluntarily registered.

The cannabis industry remained largely unregulated at the state level until 2015, when the Legislature enacted the Medical Marijuana Regulation and Safety Act (MMRSA). MMRSA comprised a package of legislation that comprehensively regulated many aspects of medicinal use cannabis including cultivation, manufacturing, transportation, distribution, sale, and product safety. In 2016, several bills made slight changes to MMRSA, including renaming MMRSA to the Medical Cannabis Regulation and Safety Act.

On November 8, 2016, California voters approved Proposition 64—the Control, Regulate and Tax Adult Use of Marijuana Act (the Act)—which legalized commercial adult-use cannabis for adults age 21 and older. Prop. 64 provides for the licensure and regulation of both commercial adult-use and medicinal use cannabis activities by various state agencies. Less than a year later in June 2017, the Legislature enacted SB 94 (Committee on Budget and Fiscal Review, 2017), which integrated MMRSA with the Act to create the Medicinal and Adult Use Cannabis Regulation and Safety Act (MAUCRSA). Among other things, MAUCRSA consolidated the licensure and regulation of both commercial adult-use and medicinal use cannabis activities. It established a system of 20 plus license categories, which includes distributor, retailer, and microbusiness, among others.

Cannabis taxes. Prop. 64, and subsequently MAUCRSA, imposes two specific taxes on cannabis: the excise tax and the cultivation tax. A customer who purchases cannabis or cannabis products in the state is subject to the cannabis excise tax, which is equal to 15 percent of the average market price of any cannabis or cannabis products retail sale. A cannabis retailer is responsible for collecting the cannabis excise tax from the customer and remitting it to the distributor. The distributor then remits the cannabis excise tax to the California Department of Tax and Fee Administration (CDTFA).

The cultivator, who grows the cannabis, is subject to the cultivation tax, which applies to all harvested cannabis at the following rates:

• $9.25 per dry-weight ounce of cannabis flower.
• $2.75 per dry-weight ounce of cannabis leaves.
• $1.29 per ounce of fresh cannabis plant.

The cultivation tax is collected by the distributor (or manufacturer), and then remitted to CDTFA. The cultivation tax does not apply to cannabis cultivated for personal use.

Internal Revenue Code Sec. 280E. In 1981, the U.S. Tax Court heard the case of Edmonson v. Commissioner, in which a drug dealer claimed deductions for cost of goods sold and business expenses, such as mileage, air fare, and packaging costs, among others, on his federal tax return. The Court determined that most of the expenses qualified as ordinary and necessary business expense deductions. In response, Congress enacted the Tax Equity and Fiscal Responsibility Act, which added §280E to the Internal Revenue Code (IRC). §280E prohibits taxpayers from deducting or claiming credits for any amounts paid or incurred in carrying on any trade or business if such trade or business consists of trafficking in controlled substances. Since cannabis is classified as a Schedule I controlled substance, a business that sells cannabis—even if for medical reasons—cannot deduct ordinary and necessary business expenses for federal tax purposes.

California’s Personal Income Tax (PIT) law conforms to IRC §280E. Thus, cannabis businesses subject to the PIT—such as a sole proprietorship or a partnership—cannot deduct their business expenses for state tax purposes. IRC §280E will cease to apply to cannabis only when Congress reclassifies the drug at the federal level.

Unlike California’s PIT, California’s Corporation Tax (CT) law is standalone law, which means the automatic denial of deductions specified by IRC §280E does not apply for state tax purposes. This allows cannabis businesses subject to the corporation tax to deduct necessary business expenses despite cannabis’s classification at the federal level.

California does have an additional law that further denies deductions—such as the cost of goods sold deduction—for income derived by a taxpayer from specified illegal activities. This applies to taxpayers under either the PIT or the CT. However, the law only applies if the taxpayer was determined to be engaged in criminal profiteering, including drug trafficking, and found to be engaged in these activities through a final determination in a criminal proceeding (AB 1369, Gatto, 2011).

The author would like to extend cannabis businesses subject to the PIT the same opportunities that cannabis businesses subject to the CT currently receive.

Proposed Law

Assembly Bill 37 specifies that the federal disallowance of tax expenditures related to the illegal sale of drugs shall not apply to licensees engaged in commercial cannabis activities subject to the PIT. By doing so, AB 37 decouples the state’s PIT from IRC §280E. The bill applies for taxable years 2019 through 2023.

AB 37 complies with Revenue and Taxation Section 41 by stating the bill’s objectives, and listing the bill’s performance indicators. AB 37 also tasks the Franchise Tax Board (FTB) with specified data collection and reporting requirements.

State Revenue Impact

According to the FTB, “every $1 billion in retail market sales would result in an estimated additional $200 million in deductions claimed resulting in an estimated revenue loss of $13 million per $1 billion in Personal Income Tax Law retail sales. In addition to expense deductions, this bill would allow commercial cannabis activities to claim tax credits. Because the amount and types of credits these businesses would claim is unknown, the additional revenue loss attributable to credits is unknown.”

According to the Assembly Appropriations Committee, “estimates of the potential size of the cannabis market range between $4 billion and $11 billion, but there remains significant uncertainty.

Comments

1. Purpose of the bill. According to the author, “The cannabis industry has multiple barriers to entry – limited access to banking, compliance with complex state regulations and a high tax burden. In addition to these challenges, the federal government continues to treat our state's legal industry as a criminal activity. Current state law conforms to federal policies that disallow tax deductions for businesses that "traffic" controlled substances, resulting in higher taxes for legal cannabis businesses. Californians voted overwhelmingly to make cannabis a legal enterprise in our state and to benefit from the tax revenue brought in by this new industry. High taxes imposed on legal cannabis products are putting the legal industry at a disadvantage in competing with the illicit market, which results in less tax revenue for the state. AB 37 will ensure that cannabis businesses are taxed like any other legal industry in our state and will help legal businesses thrive in California.”

2. Conformity. State law does not automatically conform to changes in federal tax law, except under specified circumstances. Instead, the Legislature must affirmatively conform to federal changes. Generally, when the federal government changes its tax laws, California catches up by enacting its own legislation within a few years. Currently the state generally conforms to federal tax law as of January 1, 2015 (AB 154, Ting, 2015). In general, state conformity with federal law promotes greater simplicity and eases the burden of administering complex tax law. The state should generally conform to federal law whenever possible, unless doing so is inconsistent with its policy priorities, or results in fiscal losses that necessitate cuts in public services or increased taxes. Cannabis businesses are unique because Proposition 64 and MAUCRSA allow them to operate legally under state law even though they remain illegal under federal law. As a result, California conforming to a federal law that disallows deductions for criminal business may be inconsistent with Proposition 64 and MAUCRSA. Furthermore, allowing cannabis businesses subject to the CT to deduct business expenses while disallowing cannabis businesses subject to the PIT to not deduct businesses expenses for the exact same activity is unfair. The Committee may wish to consider the merits of tax conformity for businesses operating amid a conflict between federal and state law.

3. Credits. Decoupling the PIT from IRC §280E would also allow cannabis businesses filing under the PIT to claim credits that apply to other businesses. As a result, cannabis businesses can claim any tax credit under California law if they qualify. Credits that are available to every other legal business operating in California—such as the California Competes Tax Credit and the New Employment Credit—would now be available to cannabis businesses that operate under the PIT. Furthermore, cannabis businesses subject to the CT are already allowed to claim these credits. AB 37 provides cannabis businesses subject to the PIT the same opportunity to claim tax credits as any other legal operating business in California. The Committee may wish to consider the benefit for cannabis businesses subject to the PIT and the potential increase in tax credits claimed.

4. Delayed implementation. To allow FTB time to educate taxpayers on the change in tax law AB 37 would create, the Committee may wish to amend the bill to provide for a one year delayed implementation. The Committee may also wish to delay the sunset provision by one year, to allow the bill to remain operative for five taxable years. Specifically, the Committee may wish to amend AB 37 to be available to taxpayers for taxable years 2020 through 2024.

5. Déjà vu. The Senate Governance and Finance Committee heard a similar bill last year. AB 1863 (Jones-Sawyer, 2018) contained provisions substantially similar to the current bill, which passed out of the Senate Governance and Finance on a vote of 6-0. On September 19, 2018, Governor Brown vetoed AB 1863, noting the following in his veto message:

This bill would allow licensed commercial cannabis businesses to deduct their business expenses under the state's personal income tax law, effective beginning tax year 2018. The bill seeks to apply equal state tax treatment to licensed cannabis businesses in this state, regardless of whether they organize under the personal income tax or corporate income tax law. Given the cost to the General Fund, this proposal is best evaluated as part of the budget process.

6. Section 41. In 2014, Governor Brown signed SB 1335 (Leno, 2014), which added Section 41 to the Revenue and Taxation Code. In the hopes of applying  the same level of review used for government spending programs to tax expenditure programs, including tax credits, Section 41 requires any bill introduced on or after January 1, 2015, that allows a new income tax credit to contain specific goals, purposes, and objectives that the tax credit will achieve. In addition, Section 41 requires detailed performance indicators for the Legislature to use when measuring whether the tax credit meets its goals, purposes, and objectives. This year, the Assembly Revenue and Taxation Committee adopted a new policy, requiring that all new tax expenditure proposals including sales and use tax exemptions, comply with Section 41’s requirements. As a result, AB 37:

• States that its goal, purpose, and objective of the measure is to provide equity to the cannabis industry.
• States that the detailed performance indicators are the number of deductions claimed, and the total dollar amount of deductions claimed. 
• Requires FTB to collect and report on the data specified above.

Assembly Actions

Assembly Revenue and Taxation 10-1
Assembly Appropriations 17-1
Assembly Floor 69-1

Support and Opposition

(6/7/19)

Support: California Cannabis Industry Association (Sponsor); California State Treasurer; Eric Garcetti, Mayor of Los Angeles; Conference of California Bar Associations; California Asian Pacific Chamber of Commerce; Independent California; Osiris Ventures, dba NorCal Cannabis; CMG/Caliva; Southern California Coalition; Humboldt County Growers Alliance; and Rural County Representatives of California.

Opposition: Unknown.

-- END --

ASSEMBLY THIRD READING

ATR Bill Id:AB 37

Author:(Jones-Sawyer)

As Amended Ver:March 19, 2019

Majority vote. Tax Levy

SUMMARY:

Specifies, under the Personal Income Tax (PIT) Law, that the federal disallowance of tax expenditures related to the illegal sale of drugs shall not apply to licensees engaged in commercial cannabis activities in California.

Major Provisions

1. Amends the PIT Law to provide that Internal Revenue Code (IRC) Section 280E, relating to expenditures in connection with the illegal sale of drugs, shall not apply to the carrying on of any trade or business that is commercial cannabis activity, as defined, by a licensee under the Medicinal and Adult-Use Cannabis Regulation and Safety Act (MAUCRSA).
2. Applies to taxable years beginning on or after January 1, 2019, and before January 1, 2024.
3. Takes immediate effect as a tax levy.
4. Sunsets on December 1, 2024.

COMMENTS:

1. An overview of federal law: Under IRC Section 280E, no deduction or credit is allowed for any amount paid or incurred during the taxable year in carrying on a trade or business if such trade or business consists of trafficking in controlled substances prohibited by federal or state law. The federal Controlled Substances Act, in turn, lists cannabis as a Schedule I controlled substance. As a result, a business that sells cannabis is barred from deducting what would otherwise be ordinary and necessary business expenses.
2. An overview of state law: Under state law, the treatment of ordinary and necessary business expenses from commercial cannabis activities differs depending on whether the taxpayer is subject to the PIT Law or the Corporation Tax (CT) Law.
   1. CT Law treatment: For corporations, California has standalone law. As such, the automatic denial of deductions specified by IRC Section 280E does not apply. An entity taxed as a corporation under the CT Law that is involved in commercial cannabis activities is allowed to deduct its ordinary and necessary business expenses, assuming the entity has adequate substantiating records.
   2. PIT Law treatment: The PIT Law, however, conforms to IRC Section 280E. Therefore, California follows the federal treatment of cannabis sales, and disallows a deduction for ordinary and necessary business expenses.
3. This bill: This bill is designed to equalize the treatment of taxpayers subject to the CT Law and the PIT Law by allowing taxpayers subject to the PIT Law to deduct their ordinary and necessary business expenses related to licensed commercial cannabis activities.

According to the Author:

"The cannabis industry has multiple barriers to entry – limited access to banking, compliance with complex state regulations and a high tax burden. In addition to these challenges, the federal government continues to treat our state's legal industry as a criminal activity. Current state law conforms to federal policies that disallow tax deductions for businesses that "traffic" controlled substances, resulting in higher taxes for legal cannabis businesses. Californians voted overwhelmingly to make cannabis a legal enterprise in our state and to benefit from the tax revenue brought in by this new industry. High taxes imposed on legal cannabis products are putting the legal industry at a disadvantage in competing with the illicit market, which results in less tax revenue for the state. AB 37 will ensure that cannabis businesses are taxed like any other legal industry in our state and will help legal businesses thrive in California."

Arguments in Support:

This bill is sponsored by the California Cannabis Industry Association, which states:

CCIA supports the need to reduce the tax burden on licensed cannabis businesses and strongly believes that such efforts will reduce illicit operations. By adhering to the Medicinal and Adult Use Cannabis Regulation and Safety Act (MAUCRSA), licensed cannabis businesses are paying significantly higher taxes and fees than their unlicensed competitors. The ability for these businesses to deduct their business expenses from their personal income tax will encourage compliance with California's new cannabis laws.

Arguments in Opposition:

None

FISCAL COMMENTS:

1. Significant GF revenue loss, likely in the tens of millions of dollars, each year. For every $1 billion in retail market sales for businesses that operate under PITL – such as sole proprietorships or partnerships – GF revenue loss would be approximately $13 million. Estimates of the potential size of the cannabis market range between $4 billion and $11 billion, but there remains significant uncertainty.
2. Minor and absorbable administrative costs for the Franchise Tax Board (FTB). AB 37 requires FTB to collect data on the number of deductions claimed and their total dollar amount. FTB typically already collects such data.

VOTES:

ASM REVENUE AND TAXATION: 10-1-0

YES: Burke, Brough, Chu, Gray, Mayes, Mullin, Petrie-Norris, Quirk, Luz Rivas, Ting

NO: Melendez

ASM APPROPRIATIONS: 17-1-0

YES: Gonzalez, Bloom, Bonta, Brough, Calderon, Carrillo, Chau, Diep, Eggman, Fong, Gabriel, Eduardo Garcia, Maienschein, Obernolte, Petrie-Norris, Quirk, Robert Rivas

NO: Bigelow

UPDATED:

VERSION: March 19, 2019

CONSULTANT: M. David Ruff / REV. & TAX. / (916) 319-2098 FN: 0000531

Date of Hearing: April 24, 2019

ASSEMBLY COMMITTEE ON APPROPRIATIONS

Lorena Gonzalez, Chair

ABPCA Bill Id:AB 37

Author:(Jones-Sawyer) – As Amended Ver:March 19, 2019

Urgency: No State Mandated Local Program: No Reimbursable: No

SUMMARY:

This bill specifies, for tax years 2019 through 2023, that the federal disallowance of tax expenditures related to the illegal sale of drugs does not apply under state Personal Income Tax Law (PITL) for businesses engaged in commercial cannabis activities.

FISCAL EFFECT:

1. Significant GF revenue loss, likely in the tens of millions of dollars, each year. For every $1 billion in retail market sales for businesses that operate under PITL – such as sole proprietorships or partnerships – GF revenue loss would be approximately $13 million. Estimates of the potential size of the cannabis market range between $4 billion and $11 billion, but there remains significant uncertainty.
2. Minor and absorbable administrative costs for the Franchise Tax Board (FTB). AB 37 requires FTB to collect data on the number of deductions claimed and their total dollar amount. FTB typically already collects such data.

COMMENTS:

1. Background. State and federal law generally allow business taxpayers to deduct from income any ordinary and necessary business expenses. Ordinary expenses are costs typical or common in the relevant industry or trade; necessary expenses are costs deemed helpful and appropriate for the business. Common examples of these expenses include office equipment or office rent.

Under federal law, no deduction or credit is allowed for ordinary and necessary expenses incurred in carrying on a trade or business if such trade or business consists of trafficking in controlled substances prohibited by federal or state law. Because the federal Controlled Substances Act lists cannabis as a Schedule I controlled substance, businesses that sell cannabis are barred from deducting what would otherwise be ordinary and necessary business expenses.

State law conforms to federal law under PITL, but not under Corporation Tax Law (CTL). Under CTL, California allows corporations involved in commercial cannabis to deduct their ordinary and necessary business expenses.

1. Purpose. According to the author, AB 37 will allow cannabis businesses to be taxed in the same manner as businesses in other industries.
2. Recent legislation. AB 1863 (Jones-Sawyer) and AB 420 (Wood), both of the 2017-18 Legislative Session, contained provisions substantially similar to this bill. AB 420 was held on the Senate Appropriations Committee's Suspense File. AB 1863 was vetoed by the governor, whose veto message stated:

This bill would allow licensed commercial cannabis businesses to deduct their business expenses under the state's personal income tax law, effective beginning tax year 2018.

The bill seeks to apply equal state tax treatment to licensed cannabis businesses in this state, regardless of whether they organize under the personal income tax or corporate income tax law. Given the cost to the General Fund, this proposal is best evaluated as part of the budget process.

Analysis Prepared by: Luke Reidenbach / APPR. / (916) 319-2081

Date of Hearing: April 8, 2019

ASSEMBLY COMMITTEE ON REVENUE AND TAXATION

Autumn R. Burke, Chairwoman

ABPCA Bill Id:AB 37 (

Author:Jones-Sawyer) – As Amended Ver:March 19, 2019

FOR VOTE ONLY

Majority vote. Tax levy. Fiscal committee.

SUBJECT: Personal income taxes: deductions: business expenses: commercial cannabis activity

SUMMARY: Specifies, under the Personal Income Tax (PIT) Law, that the federal disallowance of tax expenditures related to the illegal sale of drugs shall not apply to licensees engaged in commercial cannabis activities in California. Specifically, this bill:

1. Amends the PIT Law to provide that Internal Revenue Code (IRC) Section 280E, relating to expenditures in connection with the illegal sale of drugs, shall not apply to the carrying on of any trade or business that is commercial cannabis activity, as defined, by a licensee under the Medicinal and Adult-Use Cannabis Regulation and Safety Act (MAUCRSA).
2. Applies to taxable years beginning on or after January 1, 2019, and before January 1, 2024.
3. Takes immediate effect as a tax levy.
4. Sunsets on December 1, 2024.
5. Provides that it is the intent of the Legislature to apply the requirements of Revenue and Taxation Code (R&TC) Section 41 to this bill. To that end, this bill contains the following findings and declarations:
   1. The objectives of this bill are as follows:
      1. To provide tax equity to the cannabis industry;
      2. To exempt commercial cannabis activity by a licensee from IRC Section 280E, relating to expenditures in connection with the illegal sale of drugs, in order to allow cannabis businesses to claim deductions available to other legal businesses in the state;
      3. To provide commercial cannabis licensees the ability to make ordinary business deductions from taxable income in the same manner that other state businesses do for state purposes; and,
      4. To align the PIT Law with the Corporation Tax (CT) Law in relation to deductions under IRC Section 280E.
         
   2. The performance indicators related to this bill are as follows:
      1. The number of deductions claimed under R&TC Section 17209; and,
      2. The total dollar amount of deductions claimed pursuant to R&TC Section 17209.
   3. Tasks the Franchise Tax Board with the following data collection and reporting requirements:
      1. Collect data on the number of deductions claimed under R&TC Section 17209; and,
      2. Collect data on the total dollar amount of deductions claimed under R&TC Section 17209.

EXISTING FEDERAL LAW:

1. Provides that no deduction or credit shall be allowed for any amount paid or incurred in carrying on a trade or business if such trade or business consists of trafficking in controlled substances, as specified. (IRC Section 280E.)
2. Prohibits the manufacture, possession, sale, or distribution of marijuana. Congress enacted the Controlled Substances Act (CSA) as part of the Comprehensive Drug Abuse Prevention and Control Act of 1970. The CSA sets forth five "schedules" of specified drugs and other substances designated "controlled substances." For a drug or other substance to be designated as a "Schedule I" controlled substance, it must be found that the substance "has a high potential for abuse" and has "no currently accepted medical use in treatment in the United States". Federal law lists marijuana as a Schedule I controlled substance, deemed to have no accepted medical use.

EXISTING STATE LAW:

1. Consolidates the licensure and regulation of commercial medicinal and adult-use cannabis activities under MAUCRSA.
2. Defines "commercial cannabis activity" to include the cultivation, possession, manufacture, distribution, processing, storing, laboratory testing, packaging, labeling, transportation, delivery, or sale of cannabis and cannabis products, as specified.
3. Allows, under both the PIT Law and the CT Law, various deductions in computing the income subject to tax. By conforming to federal law, the PIT Law disallows a deduction or credit for business expenses of a trade or business whose activities consist of trafficking specified controlled substances, including marijuana.

FISCAL EFFECT: Unknown

COMMENTS:

1. The author has provided the following statement in support of this bill:

The cannabis industry has multiple barriers to entry – limited access to banking, compliance with complex state regulations and a high tax burden. In addition to these challenges, the federal government continues to treat our state's legal industry as a criminal activity. Current state law conforms to federal policies that disallow tax deductions for businesses that "traffic" controlled substances, resulting in higher taxes for legal cannabis businesses. Californians voted overwhelmingly to make cannabis a legal enterprise in our state and to benefit from the tax revenue brought in by this new industry. High taxes imposed on legal cannabis products are putting the legal industry at a disadvantage in competing with the illicit market, which results in less tax revenue for the state. AB 37 will ensure that cannabis businesses are taxed like any other legal industry in our state and will help legal businesses thrive in California.

1. This bill is sponsored by the California Cannabis Industry Association, which states:

CCIA supports the need to reduce the tax burden on licensed cannabis businesses and strongly believes that such efforts will reduce illicit operations. By adhering to the Medicinal and Adult Use Cannabis Regulation and Safety Act (MAUCRSA), licensed cannabis businesses are paying significantly higher taxes and fees than their unlicensed competitors. The ability for these businesses to deduct their business expenses from their personal income tax will encourage compliance with California's new cannabis laws.

1. This bill is supported by State Treasurer Fiona Ma, who states:

The federal classification of cannabis as a Schedule I substance has caused cannabis enterprises to face significant financial obstacles in entering California's legal industry. Section 280E of the Internal Revenue Code forbids businesses from deducting ordinary business expenses from any gross income that derives from the "trafficking" of a Controlled Substance. In California, the state's personal income tax law conforms to Section 280E. This means that while other businesses are able to subtract business expenses from their state taxes, cannabis businesses are prohibited from receiving deductions and must pay taxes on their gross income. Most ordinary businesses are able to profit from these deductions while compliant cannabis businesses are burdened with disadvantageous tax rates which can reach upwards of 70%.

1. Committee Staff Comments:
   1. An overview of federal law: Under IRC Section 280E, no deduction or credit is allowed for any amount paid or incurred during the taxable year in carrying on a trade or business if such trade or business consists of trafficking in controlled substances prohibited by federal or state law. The federal CSA, in turn, lists cannabis as a Schedule I controlled substance. As a result, a business that sells cannabis is barred from deducting what would otherwise be ordinary and necessary business expenses.
   2. An overview of state law: Under state law, the treatment of ordinary and necessary business expenses from commercial cannabis activities differs depending on whether the taxpayer is subject to the PIT Law or the CT Law.
      1. CT Law treatment: For corporations, California has standalone law. As such, the automatic denial of deductions specified by IRC Section 280E does not apply. An entity taxed as a corporation under the CT Law that is involved in commercial cannabis activities is allowed to deduct its ordinary and necessary business expenses, assuming the entity has adequate substantiating records.
      2. PIT Law treatment: The PIT Law, however, conforms to IRC Section 280E. Therefore, California follows the federal treatment of cannabis sales, and disallows a deduction for ordinary and necessary business expenses.
   3. This bill: This bill is designed to equalize the treatment of taxpayers subject to the CT Law and the PIT Law by allowing taxpayers subject to the PIT Law to deduct their ordinary and necessary business expenses related to licensed commercial cannabis activities.
   4. Federalism and conformity: Conforming state tax law to federal law to reduce differences between the two generally benefits both taxpayers and tax enforcement agencies alike by reducing confusion and making tax preparation easier. As such, the state should generally conform to federal law whenever possible unless doing so is inconsistent with the state's policy priorities or results in fiscal losses necessitating undesired cuts to public services. Cannabis businesses are arguably unique because they operate legally under California law, but are barred by federal law. As a result, California's conformity to a federal law that disallows deductions for cannabis businesses is inconsistent with California's clear goal of authorizing well-regulated, adult-use cannabis activities. Additionally, to the extent cannabis businesses filing under the CT Law can deduct business expenses, disallowing the same deduction for businesses filing under the PIT Law is unfair and arguably irrational. However, as marijuana remains a Schedule I substance under federal law, critics may contend that providing beneficial tax treatment to any cannabis business constitutes the encouragement of federal crimes.
   5. Credits too: This bill's decoupling from IRC Section 280E not only affects deductions, but would also allow cannabis businesses filing under the PIT Law to claim credits that are available to other businesses as well.
   6. Policy on tax expenditures: SB 1335 (Leno), Chapter 845, Statutes of 2014, added R&TC Section 41, which recognized that the Legislature should apply the same level of review used for government spending programs to tax credits introduced on or after January 1, 2015.  This Committee has recently adopted a new policy, requiring that all new tax expenditure proposals comply with the requirements of R&TC Section 41.  A tax expenditure proposal must outline specific goals, purposes, and objectives that the tax expenditure will achieve, along with detailed performance indicators for the Legislature to use when measuring whether the tax expenditure meets those stated goals, purposes, and objectives.  A tax expenditure bill will not be eligible for a Committee vote unless it has complied with these requirements. This bill has been amended to comply with R&TC Section 41 and this Committee's policy.  
      
      In addition to the R&TC Section 41 requirements, this Committee's policy also requires that all tax expenditure proposals contain an appropriate sunset provision to be eligible for a vote.  According to the new policy, an "appropriate sunset provision" shall mean five years, except in the case of a tax expenditure measure providing relief to California veterans, in which case "appropriate sunset provision" shall mean ten years.  This bill, as amended, complies with the Committee's policy.
   7. Prior legislation: AB 1863 (Jones-Sawyer), of the 2017-18 Regular Session, contained provisions substantially similar to the current bill. On September 19, 2018, Governor Brown vetoed AB 1863, noting the following in his veto message:

This bill would allow licensed commercial cannabis businesses to deduct their business expenses under the state's personal income tax law, effective beginning tax year 2018.

The bill seeks to apply equal state tax treatment to licensed cannabis businesses in this state, regardless of whether they organize under the personal income tax or corporate income tax law. Given the cost to the General Fund, this proposal is best evaluated as part of the budget process.

REGISTERED SUPPORT / OPPOSITION:

Support

California Cannabis Industry Association (Sponsor)

California Asian Pacific Chamber of Commerce

CMG/Caliva

Humboldt County Growers Alliance

Independent California

Osiris Ventures dba NorCal Cannabis

Rural County Representatives of California

Southern California Coalition

State Treasurer Fiona Ma

Opposition

None on file

Analysis Prepared by: M. David Ruff / REV. & TAX. / (916) 319-2098

Date of Hearing: March 11, 2019

ASSEMBLY COMMITTEE ON REVENUE AND TAXATION

Autumn R. Burke, Chairwoman

ABPCA Bill Id:AB 37 (

Author:Jones-Sawyer) – As Introduced Ver:December 3, 2018

FOR TESTIMONY ONLY

Majority vote. Tax levy. Fiscal committee.

SUBJECT: Personal income taxes: deductions: business expenses: commercial cannabis activity

SUMMARY: Specifies, under the Personal Income Tax (PIT) Law, that the federal disallowance of tax expenditures related to the illegal sale of drugs shall not apply to licensees engaged in commercial cannabis activities in California. Specifically, this bill:

1. Amends the PIT Law to provide that Internal Revenue Code (IRC) Section 280E, relating to expenditures in connection with the illegal sale of drugs, shall not apply to the carrying on of any trade or business that is commercial cannabis activity, as defined, by a licensee under the Medicinal and Adult-Use Cannabis Regulation and Safety Act (MAUCRSA).
2. Applies to taxable years beginning on or after January 1, 2019.
3. Takes immediate effect as a tax levy.

EXISTING FEDERAL LAW:

1. Provides that no deduction or credit shall be allowed for any amount paid or incurred in carrying on a trade or business if such trade or business consists of trafficking in controlled substances, as specified. (IRC Section 280E.)
2. Prohibits the manufacture, possession, sale, or distribution of marijuana. Congress enacted the Controlled Substances Act (CSA) as part of the Comprehensive Drug Abuse Prevention and Control Act of 1970. The CSA sets forth five "schedules" of specified drugs and other substances designated "controlled substances." For a drug or other substance to be designated as a "Schedule I" controlled substance, it must be found that the substance "has a high potential for abuse" and has "no currently accepted medical use in treatment in the United States". Federal law lists marijuana as a Schedule I controlled substance, deemed to have no accepted medical use.

EXISTING STATE LAW:

1. Consolidates the licensure and regulation of commercial medicinal and adult-use cannabis activities under MAUCRSA.
2. Defines "commercial cannabis activity" to include the cultivation, possession, manufacture, distribution, processing, storing, laboratory testing, packaging, labeling, transportation, delivery, or sale of cannabis and cannabis products, as specified.
3. Allows, under both the PIT Law and the Corporation Tax (CT) Law, various deductions in computing the income subject to tax. By conforming to federal law, the PIT Law disallows a deduction or credit for business expenses of a trade or business whose activities consist of trafficking specified controlled substances, including marijuana.

FISCAL EFFECT: Unknown

COMMENTS:

1. The author has provided the following statement in support of this bill:

The cannabis industry has multiple barriers to entry – limited access to banking, compliance with complex state regulations and a high tax burden. In addition to these challenges, the federal government continues to treat our state's legal industry as a criminal activity. Current state law conforms to federal policies that disallow tax deductions for businesses that "traffic" controlled substances, resulting in higher taxes for legal cannabis businesses. Californians voted overwhelmingly to make cannabis a legal enterprise in our state and to benefit from the tax revenue brought in by this new industry. High taxes imposed on legal cannabis products are putting the legal industry at a disadvantage in competing with the illicit market, which results in less tax revenue for the state. AB 37 will ensure that cannabis businesses are taxed like any other legal industry in our state and will help legal businesses thrive in California.

1. This bill is sponsored by the California Cannabis Industry Association, which states:

CCIA supports the need to reduce the tax burden on licensed cannabis businesses and strongly believes that such efforts will reduce illicit operations. By adhering to the Medicinal and Adult Use Cannabis Regulation and Safety Act (MAUCRSA), licensed cannabis businesses are paying significantly higher taxes and fees than their unlicensed competitors. The ability for these businesses to deduct their business expenses from their personal income tax will encourage compliance with California's new cannabis laws.

1. This bill is supported by State Treasurer Fiona Ma, who states:

The federal classification of cannabis as a Schedule I substance has caused cannabis enterprises to face significant financial obstacles in entering California's legal industry. Section 280E of the Internal Revenue Code forbids businesses from deducting ordinary business expenses from any gross income that derives from the "trafficking" of a Controlled Substance. In California, the state's personal income tax law conforms to Section 280E. This means that while other businesses are able to subtract business expenses from their state taxes, cannabis businesses are prohibited from receiving deductions and must pay taxes on their gross income. Most ordinary businesses are able to profit from these deductions while compliant cannabis businesses are burdened with disadvantageous tax rates which can reach upwards of 70%.

1. Committee Staff Comments:
   1. An overview of federal law: Under IRC Section 280E, no deduction or credit is allowed for any amount paid or incurred during the taxable year in carrying on a trade or business if such trade or business consists of trafficking in controlled substances prohibited by federal or state law. The federal CSA, in turn, lists cannabis as a Schedule I controlled substance. As a result, a business that sells cannabis is barred from deducting what would otherwise be ordinary and necessary business expenses.
   2. An overview of state law: Under state law, the treatment of ordinary and necessary business expenses from commercial cannabis activities differs depending on whether the taxpayer is subject to the PIT Law or the CT Law.
      1. CT Law treatment: For corporations, California has standalone law. As such, the automatic denial of deductions specified by IRC Section 280E does not apply. An entity taxed as a corporation under the CT Law that is involved in commercial cannabis activities is allowed to deduct its ordinary and necessary business expenses, assuming the entity has adequate substantiating records.
      2. PIT Law treatment: The PIT Law, however, conforms to IRC Section 280E. Therefore, California follows the federal treatment of cannabis sales, and disallows a deduction for ordinary and necessary business expenses.
   3. This bill: This bill is designed to equalize the treatment of taxpayers subject to the CT Law and the PIT Law by allowing taxpayers subject to the PIT Law to deduct their ordinary and necessary business expenses related to licensed commercial cannabis activities.
   4. Federalism and conformity: Conforming state tax law to federal law to reduce differences between the two generally benefits both taxpayers and tax enforcement agencies alike by reducing confusion and making tax preparation easier. As such, the state should generally conform to federal law whenever possible unless doing so is inconsistent with the state's policy priorities or results in fiscal losses necessitating undesired cuts to public services. Cannabis businesses are arguably unique because they operate legally under California law, but are barred by federal law. As a result, California's conformity to a federal law that disallows deductions for cannabis businesses is inconsistent with California's clear goal of authorizing well-regulated, adult-use cannabis activities. Additionally, to the extent cannabis businesses filing under the CT Law can deduct business expenses, disallowing the same deduction for businesses filing under the PIT Law is unfair and arguably irrational. However, as marijuana remains a Schedule I substance under federal law, critics may contend that providing beneficial tax treatment to any cannabis business constitutes the encouragement of federal crimes.
   5. Credits too: This bill's decoupling from IRC Section 280E not only affects deductions, but would also allow cannabis businesses filing under the PIT Law to claim credits that are available to other businesses as well.
   6. Policy on tax expenditures: SB 1335 (Leno), Chapter 845, Statutes of 2014, added Revenue and Taxation Code (R&TC) Section 41, which recognized that the Legislature should apply the same level of review used for government spending programs to tax credits introduced on or after January 1, 2015.  This Committee has recently adopted a new policy, requiring that all new tax expenditure proposals comply with the requirements of R&TC Section 41.  A tax expenditure proposal must outline specific goals, purposes, and objectives that the tax expenditure will achieve, along with detailed performance indicators for the Legislature to use when measuring whether the tax expenditure meets those stated goals, purposes, and objectives.  A tax expenditure bill will not be eligible for a Committee vote unless it has complied with these requirements.  The author may wish to amend this bill to specify the goals being advanced by allowing cannabis taxpayers filing under the PIT Law to deduct their business expenses.  
      
      In addition to the R&TC Section 41 requirements, this Committee's policy also requires that all tax expenditure proposals contain an appropriate sunset provision to be eligible for a vote.  According to the new policy, an "appropriate sunset provision" shall mean five years, except in the case of a tax expenditure measure providing relief to California veterans, in which case "appropriate sunset provision" shall mean ten years.  This bill, as currently drafted, does not comply with the Committee's policy. As such, the author may wish to amend this bill to add a five-year sunset.
   7. Prior legislation: AB 1863 (Jones-Sawyer), of the 2017-18 Regular Session, contained provisions substantially identical to the current bill. On September 19, 2018, Governor Brown vetoed AB 1863, noting the following in his veto message:

This bill would allow licensed commercial cannabis businesses to deduct their business expenses under the state's personal income tax law, effective beginning tax year 2018.

The bill seeks to apply equal state tax treatment to licensed cannabis businesses in this state, regardless of whether they organize under the personal income tax or corporate income tax law. Given the cost to the General Fund, this proposal is best evaluated as part of the budget process.

REGISTERED SUPPORT / OPPOSITION:

Support

California Cannabis Industry Association (Sponsor)

CMG/Caliva

Osiris Ventures dba NorCal Cannabis

Rural County Representatives of California

Southern California Coalition

State Treasurer Fiona Ma

Opposition

None on file

Analysis Prepared by: M. David Ruff / REV. & TAX. / (916) 319-2098