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Kate Amirault

Stikeman Elliott, Toronto

kamirault@stikeman.com

 

Report on conference session at the IBA Taxes Committee conference, The New Era of Taxation: what you need to know in a constantly changing world

Thursday 7 November 2019

Session co-chairs      

Francesco Gucciardo Aird & Berlis, Toronto

Juan David Velasco Posse Herrera Ruiz, Bogota

Speakers      

Jennifer E Benda Hall Estill, Denver

Juan Manuel Iglesias  Mitrani Caballero & Ruiz Moreno, Buenos Aires

Dr. Goetz Kempelmann Flick Gocke Schaumburg, Bonn

Marcelo Marchetti Ferrere, Montevideo

Gonzalo La Torre Rodrigo Elias & Medrano Abogados, Lima

Philip Ward Bennet Jones, Toronto

 

This panel used the cannabis industry as an example of a highly regulated industry where there are significant barriers to investment.

The regulation of the industry and the tax policies relating to cannabis are significantly behind other regulated industries. There remains a considerable stigma attached to cannabis as well as uncertainties related to the long-term effects of the substance. Legalisation is therefore taking longer than anticipated and is inconsistent across jurisdictions, with South America and Europe falling behind North America. A survey of various jurisdictions compares the domestic and cross-border challenges faced by cannabis businesses in these countries and demonstrates how the regulatory environment is impacting the growth of the industry.

Despite the appearance of a thriving industry, cannabis companies are generally not as profitable as perceived. Therefore, investors rely on inflated market valuations to seek return by cashing out quickly. The continued growth of the industry will depend on regulatory advancement but, until then, Canada is emerging as a world leader by demonstrating creative transaction structures to navigate these barriers.

General update by jurisdiction

Canada

Although activity has slowed in recent months, the cannabis industry has been a driver of Canadian capital market activity since medical cannabis was legalised in Canada in 2001. This has increased further since the recent legalisation of recreational cannabis in October 2018.

Nevertheless, the second stage of legalisation is ongoing and therefore, even in Canada, the cannabis industry is considered an industry in transition. For example, as of October 2019 cannabis-infused products are technically legal but are not yet available on the market.

The federal government is responsible for regulating the production and sale of cannabis, including licensing cannabis producers and performing security checks on directors. For this reason, producers tend not to be public companies.

United States

The cannabis industry is similarly in transition in the US. Cannabis remains federally illegal but has been individually legalised by many states – 33 states have legalised medical cannabis and 11 states have legalised recreational cannabis. The District of Columbia has legalised both medical and recreational cannabis. Colorado was the first state to legalise medical cannabis in 2001 and legalised recreational cannabis in 2012. For this reason, unlike Canada, licensing occurs at the state level.

At the end of 2018, commodity hemp was federally legalised. As a result, cannabidiol (CBD) products and fully compliant hemp crops will be produced as early as October 2020. However, strict ownership restrictions present hurdles to these cannabis companies becoming listed on capital markets.

Germany

In Germany, the regulatory framework for cannabis is comparable to other countries but the industry is not nearly as advanced as it is in North America. Medical cannabis was only legalised in 2017 and cultivation was legalised in 2019, with the first harvest of cannabis crops expected in 2020. However, recreational cannabis remains illegal and the import of cannabis is restricted to the Netherlands, Canada, and Uruguay. Further, there remain uncertainties with respect to the classification of CBD food products since Germany must operate under the European Union’s harmonised framework to decide how these products are classified and how they can be marketed.

Due to the current regulatory environment, there is a reluctance to fund cannabis businesses. However, the industry has a promising future in Germany since federal health care covers the cost of certain cannabis products. Germany is thus projected to be one of the top markets on the distribution side, which will be especially interesting considering its aging population.

Uruguay

Both medical and recreational cannabis were legalised in Uruguay in 2014 but the sale of cannabis products did not begin until 2017. Like other countries, the production and sale of cannabis is regulated through governmental licences (which must be renewed each year) and cannabis companies are subject to strict disclosure rules. These companies must disclose the name, legal and financial background of their shareholders and beneficiaries, and any changes in the composition of the company must be authorised by the government. Further, obtaining a licence can be cumbersome – the time to obtain a licence typically takes six to nine months at a cost of approximately $6,000 to $50,000 per year. 

Regulations also require medical and recreational cannabis to be distinguished since the sale of recreational cannabis is strictly regulated. Recreational products must be sold to local pharmacies that can only sell to local recreational consumers registered as such. The government fixes the prices of these products.  

Argentina

Medical cannabis was legalised in 2017 but recreational cannabis remains illegal. The cultivation, manufacture and marketing of cannabis and related products is currently restricted to the government and closed to private investors. However, the country is on the path toward total legalisation: provincial governments have begun implementing a regulatory framework to permit certain arrangements with foreign private investors.

Peru

Cannabis is a new industry for Peru – recreational cannabis remains illegal and medical cannabis was only legalised in 2018. As such, the related legislation is still being finalised by the Peruvian government. While the industry will be participated in by regular corporations, they will require many permits. However, it is not anticipated that these corporations will be subject to any special taxes.

Accessing capital markets and business combinations

An initial public offering (IPO) is one of several ways in which a cannabis company can go public and access capital. However, the IPO process can be expensive and time consuming.

The TSX Venture Exchange (TSX-V) offers an alternative to the traditional IPO – the Capital Pool Company (CPC) programme, which provides cannabis start-ups (other than US cannabis companies[1]) with the opportunity to effectively become listed in Canada on a fast-track basis, and thus quickly access capital. This alternative introduces seasoned investors to entrepreneurs whose growth and development stage companies require capital and public company management expertise.

A company can be listed on the TSX-V as a CPC if:

• it has no commercial operations and no assets other than cash; and

• it completes a qualifying transaction (QT) within 24 months of listing by acquiring an operating company.

A QT is often completed as part of a reverse takeover (RTO) by a private company seeking access to public capital. The process is more efficient than an IPO because the CPC will have already completed all the necessary steps to obtain a listing on the TSX-V. Nonetheless, the parties will still need to prepare a disclosure document containing prospectus-level disclosure on the CPC, the private company and the resulting issuer (a filing statement or, if the transaction requires shareholder approval, a management information circular).

Unlike the TSX and TSX-V, the Canadian Stock Exchange (CSE) will list a US cannabis company. Although the CSE does not have an equivalent CPC program, it is possible to achieve the same result through a business combination with an already-listed shell company (often a defunct mining company) rather than an RTO, and then access capital through a subsequent private placement.

The RTO or business combination can be structured in several ways, including an amalgamation or a share exchange and, in the case of a CPC, most often involves the CPC acquiring all the shares of the private company in some manner in exchange for the issuance of the CPC’s shares to the former shareholders of the private company.

RTO – merger

A company (X Co) incorporated in a jurisdiction other than Canada (Jurisdiction X) can access the capital markets by way of a triangular or three-corner amalgamation with a CPC or shell company as follows:

 

• the CPC/shell will incorporate a subsidiary in Jurisdiction X (MergerSub);

• MergerSub and X Co will merge or amalgamate to form a single entity; and

• on the merger or amalgamation:

• the shareholders of X Co (capital investors and founders) will receive shares of the CPC/shell in exchange for their shares in X Co;

• management will receive replacement options/warrants, etc. in the CPC/shell for their options/warrants, etc. in X Co; and

• the merged entity will be wholly owned by the CPC/shell (see Figure 1).

Figure 1: triangular or three-corner amalgamation

 

Generally, a transfer to a foreign corporation will be a taxable transaction. Therefore, if Jurisdiction X is one of the jurisdictions discussed above (other than Canada) the merger will be an inefficient structure from a tax perspective. The laws of several countries – such as Argentina, Germany and Peru – do not contemplate triangular mergers or an equivalent structure. Therefore, even when the resulting shareholders are from Jurisdiction X, it is not possible to classify the merger as a tax-deferred or tax-favoured reorganisation. As a result, this structure may present significant tax consequences for shareholders, management and the cross-border use of intellectual property.

RTO – share exchange

In this alternative, X Co will access the capital markets by way of a direct share exchange among its shareholders and the CPC or the shell company as follows:

• the shareholders of X Co (capital investors and founders) will transfer their shares in X Co to the CPC/shell in exchange for shares in the CPC/shell; and

• management will exchange their options/warrants etc, in X Co for options/warrants, etc, in the CPC/shell (see Figure 2).

 

Figure 2: RTO for share exchange

Unlike a triangular merger, a share exchange by Canadian shareholders may be eligible for tax deferral on a rollover basis. However, this structure may not provide tax deferral for shareholders of other jurisdictions. It is therefore common to see a bifurcated structure, in which the Canadian shareholders participate in the share exchange while foreign shareholders flip up into the Canadian corporation by merger.

Deferring recognition – exchangeable share structure

If the structured transaction is not be eligible for tax deferral in Jurisdiction X, then consideration might be given to implementing an ‘exchangeable share’ transaction to align the taxable event with the actual liquidity event.

Under this structure, shareholders would exchange their shares in X Co for preferred shares of X Co/MergeCo that are redeemable or exchangeable for shares of the CPC/shell on some pre-defined basis and which are ‘economically equivalent’ to the shares of the CPC/shell (see Figure 3). If the exchange of shares in X Co for exchangeable shares of X Co qualifies for a deferral, shareholders would retain an interest at the X Co level and trigger the redemption/exchange feature to coincide with an eventual liquidity event.

Figure 3: exchangeable share transaction

This is now the main structure used in Canada, although Canadian tax considerations are not the driving force. Rather, the popularity of the structure is due to regulatory and securities law considerations, as well as foreign tax considerations related to the jurisdiction of the vendor.

Despite the solutions to certain tax considerations in other jurisdictions, one issue that remains is whether the exchangeable share structure will be considered moot and will result in a taxable gain on each exchange. Unfortunately, there is no single answer since it will depend on the laws of Jurisdiction X.

US inversions

Many RTOs between Canadian and US corporations have triggered an inversion. The result of an inversion is that the Canadian corporation is deemed, for US federal income tax purposes, to be a US corporation. An inversion is typically triggered when US shareholders own 80 per cent or more of the vote or value of the Canadian corporation. Since, for US purposes, the Canadian parent is deemed to be a US corporation, the share exchange transaction qualifies under the US tax-free reorganisation rules to provide US shareholders with a deferral.

Despite the tax-free reorganisation, cross-border tax becomes relevant when the corporation begins production and earns income. Although the profits of these corporations are primarily reinvested, and therefore distributions are limited, US withholding tax will apply in respect of dividends paid by the CPC/shell to non-US holders: Canadian withholding tax will apply in respect of dividends paid by the CPC/shell to non-Canadian holders. A holder that is both non-US and non-Canadian would be exposed to both Canadian and US withholding tax on the same distribution. The US withholding tax rate is 30 per cent and the Canadian withholding tax rate is 25 per cent: in each case, subject to reduction under an applicable tax treaty. It is possible that these withholding tax amounts will be eligible as a foreign tax credit; however, a problem arises when it comes to determining what portion of the dividend will be considered from a foreign source for US and Canadian shareholders respectively.

Further, a US inversion limits the Canadian tax consequences only to the extent that the operations are primarily US-based. Canadian tax consequences are of greater concern when the inverted company is used to develop a business in Canada or to access Canadian intellectual property. There may even be personal tax implications for executives and other employees that perform services in Canada.

It is also necessary to consider the tax consequences to shareholders in other jurisdictions. Depending on the amount of equity injected through the private placement, it is possible that the ownership of the existing US shareholders of X Co will be diluted to below the 80 per cent threshold. Shareholders from jurisdictions other than Canada and the US are often not in favour of an inversion and may attempt to avoid an inversion in this way. However, it will likely result in a difficult business relationship with the majority shareholders.  

Figure 4: US inversion

Investment in US cannabis companies

Current US issues

Historically, cannabis businesses in the US faced federal prosecution despite being legal at the state level. Although these businesses are now temporarily protected from federal prosecution, US federal income tax has not yet adapted to recognise these legitimate businesses, which can significantly impact the overall profitability of cannabis companies (see Table 1). Specifically, section 280E of the Internal Revenue Code prevents business deductions or credits for expenditures in connection with the illegal sale of drugs as follows:

‘No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of Schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.’

Section 280E was enacted in response to Edmundson v Comm’r (T.C. Memo. 1981-623), which permitted an illegal drug trafficker to deduct his ordinary and necessary business expenses incurred in his illegal drug business. Legislators reasoned that, since there is a sharply defined public policy against drug dealing, to allow drug dealers the benefit of business expense deductions while the country and its citizens are losing billions of dollars per year to such persons is not compelled by the fact that such deductions are permitted for other, legal, enterprises. However, to preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective cost of goods sold is not affected by this provision of the bill.

Table 1: Section 280E illustration

Note that the Agricultural Improvement Act of 2018 provides relief from section 280E for hemp products, which include products with less than 0.3 per cent tetrahydrocannibinol (THC). The Act provides for federal licensing of hemp producers through state programmes approved by the Department of Agriculture. The federal government has 60 days after state applications are submitted to approve or deny state programs. Hemp produced under these programs is excluded from definition of ‘marijuana’ under the Controlled Substances Act and are thus excluded from the application of section 280E. The first fully compliant crop is expected to be harvested in October 2020. 

Another issue faced by US cannabis companies is the disconnect between the state and federal income tax regimes. In certain states, such as Alaska, New Hampshire, New Jersey and Pennsylvania, the application of section 280E varies based on whether the taxpayer is an individual or a corporation. There are also incongruities in terms of the treatment and deductibility of expenses or fines and penalties incurred by illegal ventures in non-US jurisdictions.

Sales and excise taxes are also state-specific but generally there is lower or no sales tax on medical cannabis (this is sometimes dependent on how the state taxes prescription drugs) and higher sales tax for recreational cannabis. Similarly, while only some states apply excise tax to medical cannabis, most apply the tax to recreational cannabis.

Canopy/Acreage transaction example

This year, Canopy Growth Corporation, a Canadian company listed on the TSX, agreed to acquire, by way of a plan of arrangement (POA), Acreage Holdings Inc, a Canadian company with US cannabis operations listed on the CSE. The POA was implemented under Canadian law and provided Canopy with an option to acquire all the Acreage shares on the basis of 0.5818 Canopy shares for each Acreage share, which exchange will be automatic if and when cannabis becomes federally legal in the US and provided that legalisation occurs within 7.5 years of the date of the agreement (the ‘triggering event’). In consideration and as an inducement, Canopy paid US$300m in cash to Acreage shareholders (the ‘premium payment’). The total value of the deal, if Canopy exercises its option under the plan of arrangement, is US$3.4 billion.

The tax treatment of the premium payment and exchanges is complex. It appears the triggering event can and is planning to be waived at some point in time; therefore, it will be difficult in the US to rely on the open transaction doctrine to determine the tax of the option premium payment to shareholders for US purposes.

An important practice note is the inclusion of a US-style ‘survivor clause’ in the Canadian POA. Under Canadian law, an amalgamation of two or more companies results in the creation of a new company. Adding a survivor clause as such ensures that the acquired company, in this case Acreage survives the merger. Canadian courts have been liberal and accommodating in this regard, approving by way of court order POAs that include this language, notwithstanding Canadian statutes. The hope is that US practitioners become comfortable that this language is sufficient to prevent the tax consequences that otherwise arise on a Canadian amalgamation.

This transaction perfectly illustrates the leadership exercised by Canadian companies and lawmakers with respect to the cannabis industry. This structure provides Canopy with access to the US market while circumventing the TSX’s restrictions on investing in US cannabis companies as long as cannabis is federally illegal. It is important to note, however, that the arrangement effectively requires Canopy to bet on the future of US cannabis laws. Although the arrangement provides Canopy with some relief if the triggering event does not occur, the company will lose the bulk of the US$300m consideration paid up-front if not finally consummated.

Certain industry experts predict that cannabis will become legal in the US within the next two election cycles. However, others are less confident and there is even less certainty with respect to the regulatory environment of other markets, such as South America and Europe. As a result, it is still unclear whether the projected growth of the industry is currently overestimated. Nevertheless, Canada is demonstrating creative solutions to these legal uncertainties and represents promise for the continued growth of the industry.

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