California: IRC Sec. 280E and Transportation

This post was prompted in part by some of the questions we have received regarding IRC Sec. 280E.¹ Some in the cannabis industry appear to not realize that IRC Sec. 280E applies to the industry before the retail [Dispensary] level.

We begin a series of posts relating to IRC Sec. 280E with a discussion of the application of this issue to the transportation [e.g. how an item gets from “here” to “there”] of cannabis.

The framework for our discussion is the commercial cannabis industry in California.

The three principal governmental agencies involved in the promulgation of cannabis regulations relating to transportation are: the Bureau of Cannabis Control (“BCC”); the California Department of Public Health (“”CDPH”); and the California Department of Food & Agriculture (“CDFA”).

Other California governmental agencies with a significant interest in the application of these regulations include: the California Department of Tax and Fee Administration (“CDTFA”); the California Highway Patrol (“CHP”); the Division of Occupational Safety and Health (“CAOSHA”); and State of California Economic Development Department (“EDD”).

The principal bodies of existing California law relating to transportation are found in the California Vehicle Code and the California Uniform Commercial Code.

The regulations relating to cannabis transportation conflict with existing laws and regulations as well as established commercial practices relating to transportation. In those instances in which federal or California law already addresses a particular topic, or for which there are time-honored commercial practices involving the commercial movement of commodities, California’s cannabis regulations must be interpreted and applied in a manner that does not severely conflict with already established rules of law. If the conflicts are too severe, the cannabis regulations are likely to be determined to be preempted and not enforceable.

California’s regulations relating to the transportation of commercial cannabis are founded on the utilization of a Manifest to facilitate the tracking of all commercial cannabis from source to consumer. A Manifest as the word is used in California’s cannabis regulations is specialized form of record of selected shipping information. The Manifest specified by California’s cannabis regulations is a subset of the information addressed generally in commercial shipments in a Bill of Lading. The Manifest specified in California’s cannabis regulations requires some information that would not be required by most commercial Bills of Lading. California’s cannabis regulations also specify more extensive record retention requirements than would be followed in general commercial practices. However, the Manifest specified by California’s cannabis regulations also appears to not have considered a wide-range of matters that may be addressed in Bills of Lading.

Bills of Lading are generally divided into two principal categories – negotiable and non-negotiable Bills of Lading. Notwithstanding this simple division into two categories, there are an almost infinite variety of special provisions dictated by the special requirements associated with specific materials or forms of transportation. The fundamental difference between a negotiable and a non-negotiable Bills of Lading turns on whether title to the material being transported passes on the delivery of the material to the transporter. One question which must be asked is whether the establishment of a transportation-only classification of transporter in California’s regulations considered whether such a business could utilize both negotiable and a non-negotiable Bills of Lading

We begin our analysis by defining a number of terms which are a prerequisite to understand the discussion which follows:

• “FOB Shipping Point”- is a contraction of the term “Free On-Board Shipping Point.” The term means that the buyer takes delivery of goods being shipped to it by a supplier once the goods leave the supplier’s shipping dock. Since the buyer takes ownership at the point of departure from the supplier’s shipping dock, the supplier should record a sale at that point. The Buyer assumes the risk of loss for goods from that point as well. The Buyer is responsible for the cost of shipping the goods.

• “FOB Destination” is a contraction of the term “Free On-Board Destination.” The term means that the buyer takes delivery of goods being shipped to it by a supplier once the goods arrive at the buyer’s receiving dock. The supplier records the sale when the goods are received by the buyer and bears the risk of loss while the goods are in transit. The supplier is usually responsible for the shipping cost.

• “Transport” means the physical movement of cannabis goods from one licensed premises to another licensed premises. Reg. Sec. 5000 (r)

• “Transportation Procedures²” – A description of the applicant’s procedure for transportation of cannabis goods, including whether or not the applicant will be transporting cannabis goods or contracting for transportation services. Reg. Sec. 5002 (c)(29)(A)(i)

• “Track and Trace System” – A licensee shall create and maintain an active and functional account within the track and trace system prior to engaging in any commercial cannabis activity, including the purchase, sale, test, packaging, transfer, transport, return, destruction, or disposal, of any cannabis goods. Reg. Sec. 5048(a)

• Shipping Manifest – The document which is required to accompany any commercial cannabis shipment, with specifically enumerated information³

• “Distributor” Distributor licensees are responsible for transporting cannabis goods, arranging for testing of cannabis goods, and conducting quality assurance review of cannabis goods to ensure they comply with all the packaging and labeling requirements. Distributor transport licenses allow for the transport of cannabis goods between licensed cultivators, manufacturers, and distributors. A distributor transport licensee may not transport cannabis goods to a licensed retailer and may not engage in any other distributor activates There is a specific definition provided for a “Distributor Transport Only License⁴”

• “Retailer” A Retailer (storefront) sells cannabis goods to customers at its premises or by delivery. A retailer must have a licensed physical location (premises) where commercial cannabis activates are conducted. A retailer (non-storefront) licensee must have a licensed premises, but it is not open to the public.

• “Manufacturer” means any involved in any aspects of the extraction process, and/or infusion process, and packaging and labeling processes, including processing, preparing, holding, and storing, packaging, or labeling of cannabis products. Manufacturing also includes any processing, preparing, holding, or storing of components and ingredients.

• “Cultivator” means anyone involved in any activity involving the planting, growing, harvesting, drying, curing, grading, or trimming of cannabis Reg. Sec. 8000(g)

Commercial cannabis originates with a Cultivator that is in simple terms, a farmer⁵. The expenditures made by a Cultivator in producing a cannabis crop are, in general, classified as “Cost of Goods Sold”. So long as the Cultivator refrains from engaging in other activities which bring them closer to the “line” with activities that cross over into Distribution, a Cultivator should have minimal exposure to falling within the ambit of IRC Sec. 280E. [We will revisit the topic of Cultivator’s engaging in other activities in a separate post.]

Consider two minor variations in the same simple transaction – a Cultivator sells cannabis to a Distributor or Manufacturer. The focus of this scenario is on the classification of transportation costs. In the first alternative, the Cultivator sells the cannabis to a Distributor, for a set price with shipping terms, FOB Shipping Point. The Cultivator gets paid for the cannabis and the transportation costs are paid directly by the Distributor. In the second alternative, the Cultivator ships OB Destination and pays the transportation costs. The final delivered cost of the cannabis is identical under both scenarios. Some may assert Cultivator’s payment of the transportation costs in the second alternative will cause the transportation costs to be exposed to disallowance under to IRC Sec. 280E because transportation constitutes a “trafficking” expense in many instances.

While there is no clear definition of trafficking, we do not believe IRC Sec. 280E should apply the transaction for two reasons:

• The results in both alternatives are identical. We believe the party that pays in an otherwise identical transaction that does not otherwise change the substance of the transaction should alone cause a different result for income tax purposes.

• More importantly, the Cultivator has not in our opinion engaged in sufficient activities constituting trafficking to appear to has crossed into the Distributor type activities which constitute trafficking, such as testing, packaging for retail sale, and labeling.

Where cannabis is transported to a Manufacturer, a similar analysis should apply. We further believe that a similar result applies to transportation costs are incurred in bringing other supplies which are used in the extraction process such as alcohol, propane, etc.

Where a Distributor operates as a Transport Only business, the distributor appears to be solely performing a service provider role. The operating costs of such a business should NOT fall within IRC Sec. 280E as such a business is merely functioning as a shipping company. We will consider the activities of a Distributor that does more than transport and deliver in a subsequent post.