Canada/US Cross-Border Cannabis Issues

Article by Cheryl V. Reicin and Shane Thomas, with William F. Gray Jr., Kevin Tuohy, Lift News

Canada/US cross-border cannabis issues An introductory overview comparing the U.S. and Canadian landscape and the resulting cross-border issues

The cannabis industry is booming and blooming, both in the U.S. and in Canada. Canada is gearing up for legalization of recreational use on July 1, 2018. In the U.S., seven states and the District of Columbia have legalized the recreational use of cannabis, and an additional 22 states have legalized medical cannabis. But at the federal level, the selling and use of cannabis product remains illegal with no plans in sight for legalization.

This article will provide an introductory overview comparing the U.S. and Canadian landscape and the resulting cross-border issues.

Investing in U.S. cannabis companies

No cannabis-based company—U.S. or foreign—may list on any of the U.S. stock exchanges or NASDAQ and as a result, many cannabis-based companies trade in the over-the-counter market. However, seven companies engaged in the research, development and commercialization of cannabinoid-based therapeutics are listed on NASDAQ. These seven companies are regulated by the FDA and cannabinoids can be produced synthetically to yield the desired clinical outcome, thereby alleviating the reliance on native cannabis product.

Currently, U.S. cannabis companies cannot list on the Toronto Stock Exchange (TSX) or its cousin, the Toronto Venture Exchange (TSXV) as a result of the legal status of cannabis activity in the U.S. Uncertainty over the Trump administration’s enforcement policy of federal cannabis laws has resulted in a chilling effect on TMX Group’s (operator of the TSX and TSXV) willingness to list U.S. companies in this sector. Under the Rohrabacher-Farr Amendment to the current U.S. Omnibus Spending Bill, federal funds cannot be expended on the enforcement of federal cannabis laws in states where the cannabis business is legal. This Amendment does not alter the illegality of cannabis under federal law but does shield cannabis operators in states where they are conducting legal activity.  The Amendment is subject to review each year and is currently set to expire on December 9, 2017. Attorney General Jeff Sessions has written to Congress asking the Amendment not be renewed. A decision on the continuation of the Rohrabacher-Farr Amendment looms large as an indication of the Trump administration’s position on the development of U.S. cannabis industry.

An alternative stock exchange, the Canadian Stock Exchange (CSE), will list U.S. cannabis companies. As a result, this exchange is gaining traction. In a notice released by the CSE on August 4, 2017, the CSE reiterated its commitment to accept listing applications from U.S. cannabis companies so long as they meet the CSE’s minimum requirements for listing.

Canadian cannabis companies may list on the TSX and TSXV. As of November 1, 2017, over C$540 million has been raised by these companies in prospectus offerings on those exchanges. Once public, some of these Canadian companies have entered into partnerships or otherwise acquired interests in U.S. cannabis-related operations. Questions surrounding the permissibility of these transactions gained considerable attention in the industry, and as a result, TMX Group released a bulletin on October 16 in an attempt to clarify this situation. In the bulletin, TMX Group confirmed its long-standing position that issuers who violate U.S. federal laws are in fact non-compliant with listing requirements. Furthermore, TMX Group will take proactive measures to thoroughly review issuers who either have direct business interests or engage in ancillary services in the U.S. cannabis sector. It remains to be seen how TMX Group will act upon completion of its review.

Opportunities for foreign-based companies in Canada

As a result of the disparity between the public financing options in the U.S. versus Canada, Canada has taken the lead in financing cannabis-based companies—both domestic and foreign. Canadian investment dealers and bankers are seen as building up expertise in this sector, which has attracted significant foreign investment. As a result, companies based in Israel, Germany and Uruguay are looking to Canadian markets as the primary funding centre. The traditional Canadian banks have thus far shied away from underwriting offerings of cannabis-based companies, largely for fear of violating any U.S. laws and jeopardizing their U.S. franchise; therefore, to date, it is the boutique investment banking firms that have led most of the cannabis-related financing efforts.

Private placements for companies in this industry have been taking place on both sides of the border. As of November 1 over C$1.3 billion has been raised through the private placement of shares by North American cannabis-related companies this year. As Canadian LPs increase their capacity to service the upcoming legalized recreational market in Canada, the size of these deals are expected to increase. For example, Canopy Growth recently closed a C$245 million deal with Constellation Brands on October 30 to fund, in part, new product development and research

Banking

Until recently, traditional  banks in the U.S. or Canada have not yet opened the door to support cannabis-based companies. In June 2011 the Department of Justice released “Cole 1” and in August 2013 released “Cole 2”—referred to collectively as the “Cole Memo,” which was created to assure the public how enforcement of cannabis-related laws would be limited. However, a companion memo to Cole 2 required such complex and impractical monitoring of a financial or banking relationship rendering it all but impractical for banks to service any business remotely touching a marijuana plant.

Credit unions and regional banks have stepped into the breach left by banks; but services tend to be more limited than that required by companies carrying on an international business. The Bank of Montreal and Toronto-Dominion Bank, for their part, have recently opened their doors to cannabis companies by providing business accounts. Concurrently, opportunities exist for alternative banking systems both within and outside traditional banks. Also, we expect the public security risks of having cannabis-based businesses retain large amounts of cash on premises to likely motivate legislatures and other governmental bodies to address these issues.

Tax Planning

U.S. cannabis companies are treated as illegal enterprises for federal tax purposes—subject to tax on all revenues and proscribed from deducting ordinary course expenses. In 1982, Congress enacted IRS Section 280 E, which prohibited deductions or credits for a business or trade involved in the trafficking of a controlled substance. The provision was in response to an earlier Tax Court case that permitted a taxpayer to recover its cost of goods sold and ordinary course expenses. As a result, while direct costs of goods may be deducted—one may take deductions for growing a plant but not selling a plant—the cost of salespeople and overheads cannot be expensed and therefore effective tax rates can be extremely high. There are, however, structures being used to reduce such taxes.

U.S. cannabis producers, unlike dispensaries, would be able to recover much of its expenditures as cost of goods sold, however, the extent to which these businesses touch on ‘trafficking’ activities may limit the scope of available deductions. Nevertheless, states like Hawaii have adopted legislation rendering the state-equivalent of 280 E inoperative, in an effort to neutralize the consequences of state-level incomes tax laws that traditionally have mirrored federal income tax laws. The extent to which Hawaii is a harbinger or outlier, as it relates to other states, is difficult to ascertain at this time. Therefore, cross border tax planning to reduce taxes is not only desirable but may be required in order to effectively compete and operate in this sector.

Trademarks

In Canada registrations may be obtained for trademark covering various strains and brands of cannabis. In the U.S. it is not possible to obtain registrations for trademarks covering cannabis-based products because they are a Schedule I drug. The U.S. federal trademark regime will not register marks that when used commercially result in a violation of federal laws (referred to as the “Lawful Use Rule”). Attempts to gain U.S. federal trademark protection by relying on foreign registration have proven ineffectual. A condition precedent to registration under the U.S. regime is the applicant demonstrating actual commercial use or an intent to use the mark in question. So long as cannabis is prohibited under U.S. federal laws, the “use” requirement is impossible to overcome.

There are, however, less appealing options for trademark protection in the U.S., namely state-level registration, reliance on common law rights, or registration for marks covering goods or services related to cannabis. State-level registration provides some measure of protection, with the obvious caveat that national protection is not afforded. States that have legalized cannabis for medical use, or both medical and recreational use, have granted registrations for marks covering cannabis-based products. This is not true for every state in which cannabis use is permitted. For example, California has decided not to issue state-level registrations for marks covering products that would violate U.S. federal cannabis laws. Common law rights, on the other hand, arise when a mark is first used commercially. No federal registration is required, but the protection is more limited, and typically only extends to the immediate geographic area where the trademark is used. The extent to which common law rights can form a sufficient legal basis for a claim of infringement arising out of the commercial use of a federally prohibited substance has been untested to date in federal courts.

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