For cannabis customers, normal tax planning is reversed: the goal is to capitalize as many costs as possible instead of asking for deductions.
This is thanks to Section 280E tax code, which prevents cannabis companies and other “drug traffickers” from reducing gross income through deductions. On the other hand, when a cannabis company sells real estate, it can reduce the amount realized on an adjusted basis and reduce gross income through the cost of goods sold when calculating gross income. Better to capitalize costs and recover them later than not recover them at all.
Until recently, the Section 280E activated base exemption was more useful for some cannabis companies than for others. According to Section 471 (a), retailers and distributors could not capitalize costs as aggressively as manufacturers. However, Congress appeared to expand this exemption in 2017 when it added Section 471 (c) as part of the TCJA. This new provision appeared to say that a qualified taxpayer could choose any method of accounting for inventory – including one that allocates additional expense to inventory – as long as it “conforms to the books and records kept under the terms of the taxpayer’s accounting process. “In this case, retailers and distributors could choose to be treated like producers.
In the proposed and final rulings, the Treasury Department challenged the idea that Section 471 (c) removes existing capitalization limits. REG-132766-18 (August 5, 2020); TD 9942 (January 5, 2021). We would rewrite the Treasury Department’s argument as follows:
- Section 471 is located in Chapter 1 Subsection E “Accounting Periods and Accounting Policies” and not in Chapter 1 Subsection B “Calculation of Taxable Income”.
- Therefore, it is a timing, not an essential tax regulation.
- A timing determination cannot be used to convert nonrefundable costs into reimbursable costs.
- It can therefore not be used to capitalize costs that otherwise cannot be capitalized and are not deductible.
If the Treasury Department is right, this new tech can join its friends in the burgeoning scrap heap Section 280E. However, we do not believe the Treasury Department is right.
The rule contradicts section 471 (a).
Of course, § 471 can be used to capitalize otherwise non-deductible and non-capitalizable costs. It is undisputed that manufacturers can capitalize on costs that retailers cannot, including costs that are non-deductible under Section 280E. In both cases this difference in treatment is caused by the requirements of 471 (a).
Since retailers are denied treatment of manufacturers by Section 471 (a) and Section 471 (c) overrides the requirements of this provision, it follows that Section 471 (c) does what we believe: it removes the obstacle that prevents has retailers capitalizing on costs like producers can.
The rule contradicts Section 280E
Even if the Treasury Department is correct that Section 471 will refuse capitalization if a withdrawal is refused, there should be an exception if section 280E refuses to withdraw. When Congress passed Section 280E, it was clear that taxpayers could bypass the provision by capitalizing on the cost. Legislative history confirms that this behavior was not questioned, but expressly approved. S. Rept. 97-494 (Vol. 1): 309 (1982).
Even the Treasury Department recognizes this. In the words of the US Treasury Court, the Treasury Department recognized “that the non-admission of Section 280E does not apply to the cost of goods sold, a concession that is consistent with the case law on the matter and legislative history, Sec. 280E. “Californians Help Relieve Medical Problems, Inc. vs. Comm’r. The Treasury Department has also implicitly admitted the point in previous regulations: Outside of Section 471 (c), the Treasury Department refuses to capitalize on illegal bribes, fines, and triple antitrust damages only, which confirms that the capitalization is fine in other cases Treasury Regulation Section 1.471-3 (f).
The rule contradicts the preamble
The last rule also contradicts the Treasury Department’s statement in a preamble that Section 471 (c) is “an inventory exception”. If so, we would expect the final rule to prohibit retailers from using Section 471 (c) to capitalize otherwise deductible costs. But nothing in the preamble suggests why that should be so, and it is not in the final rule.
The rule invents the distinction between timing and substance
In contrast to other provisions of the Tax Code, Section 471 does not expressly prohibit the activation of non-deductible amounts. To read such a disallow rule in Section 471, the Treasury Department claims that it is a “timing”.
However, the Treasury Department does not offer valid evidence to support this idea. It refers to the inclusion of Section 471 (c) in the Tax Code, but Section 7806 provides that “no inference, implication, or presumption of any legislative construction may be drawn or drawn from the location or grouping of a particular Section or provision or part of this title. “That makes sense; Congress cannot always codify new laws in the right places, especially when, as Boris Bittker noted, many accounting rules“ have both accounting and content-related aspects ”.
In addition, the distinction between “time” and “content” rules has become irrelevant. Again citing Bittker: It is “far from clear” whether the special provisions that we call accounting methods are “mini-accounting methods” or should instead be viewed as rules of substantive tax law. For example, there are many regulations that the Treasury Department would consider substantial but that affect timing. These include:
- Section 280B (Transfer of Base from Demolished Structure to Land); Section 280F (Limitation of Depreciation of Certain Motor Vehicles);
- Section 179 (Permission to deduct certain costs that would otherwise have been capitalized);
- Section 174 (Permission to deduct research and experimental expenses that would otherwise have been activated); and
- Section 83 (Permission for the belated inclusion of property received as compensation for services).
Conversely, there are provisions that the Ministry of Finance would characterize as time rules, but which have a significant effect. For example:
- When a business expense is capitalized into a net present value, its tax protection value is depreciated.
- When a company sells capital assets for a loss, Section 1212 will not allow that loss unless it is used within five years.
- The business loss limitation in Section 461 (l) is an accounting method but creates net operating losses (NOLs) which the Treasury Department has determined to be substantive. Section 461 (l) became law in the TCJA alongside Section 471 (c), suggesting that Congress was indifferent to the distinction when it passed Section 471 (c).
- The installment payment method in Section 453 is basically a non-recognition provision. Although the property exchanged (the note) does not receive a top-up on death, the taxpayer can bear the tax with long-term balloon payments. Much tax controversy revolves around efforts to defer tax in this way. Both sides would be surprised to learn that these issues are not “substantial”.
If cannabis taxpayers continue to use Section 471 (c) to bypass Section 280E, they will need to disclose this on Form 8275-R when the new regulation goes into effect, that is, for tax years on or after January 5, 2021 begin. Section 1.471-1 (c). This disclosure will invite an audit. If the 2022 law conforms to today’s law, the test will end on a flaw.
However, if the taxpayer complains about this deficiency in court, she could use these points to argue that the regulations are against the APA. Specifically, under Section 553 (c) of the APA, the rule may be foreclosed in the absence of an explanation of the basis and purpose of the rule that adequately relates the rule to promoting the objectives of the underlying law. Similarly, Section 706 of the APA provides that a court may overturn and overturn any unlawful acts, determinations and conclusions of the Agency that are found to be arbitrary, capricious, an abuse of power, or otherwise inconsistent with the law or in breach of the procedure prescribed by law .
This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owners.
Information about the author
Andrew Gradman is a tax attorney. Abraham Finberg and Rachel Wright are principals at AB FinWright LLP.
Bloomberg Tax Insights articles are written by seasoned practitioners, academics and policy makers to discuss developments and current tax issues. To make a contribution, please contact us at [email protected].