When the curtain finally closes on 2018, it will likely be remembered as the greatest year in cannabis history. To our north, Canada cast aside nine decades of recreational marijuana prohibition and legalized adult-use weed. Although it'll take a few years for growing capacity to be fully ramped up, recreational legalization should add in the neighborhood of $5 billion in annual sales by early next decade.
Meanwhile, in the U.S., a handful of states gave the green light to medical or recreational cannabis. There are now 32 medical marijuana-legal states and 10 that allow adult-use pot. We also witnessed the first cannabis-derived drug gain approval from the U.S. Food and Drug Administration.
The U.S. cannabis industry faces multiple hurdles
Yet in spite of the cannabis industry gaining validity and a wide following from Wall Street and retail investors, there's still plenty of room for improvement -- especially in the U.S., where federal regulations make life difficult for weed companies. One such obstacle for marijuana companies is Section 280E of the U.S. tax code, which was passed in 1982.
Section 280E reads as such:
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.
In plain English, this tax code disallows businesses that sell a federally illicit substance from taking normal corporate income tax deductions, save for cost of goods sold, which tends to be a small percentage of revenue. As a Schedule I substance, marijuana is wholly illegal, prone to abuse, and has no recognized medical benefits. That leads to some profitable pot companies paying an effective tax rate of as much as 70% to 90%. As a result, U.S. marijuana businesses aren't able to put their operating income to work like a normal business, which can constrain hiring, expansion, and even orders to resupply product.
Cannabis businesses in the U.S. are also plagued by having very limited banking options. Even though nearly two-thirds of U.S. states have legalized marijuana in some capacity, banks fear the criminal and/or financial repercussions of providing basic banking services to pot companies. This has left much of the industry underbanked and reliant on cash.
McConnell gives the States Act the boot
With this in mind, one lawmaker in Washington is attempting to remove at least one of these hurdles for the rapidly growing U.S. cannabis industry.
Earlier this week, Sen. Cory Gardner (R-Colo.) reintroduced the States Act, which is designed to protect the interests of states with regard to marijuana. In particular, it would recognize that compliant transactions in legalized states aren't considered "trafficking," which would therefore no longer constitute an unlawful transaction by the federal government's definition. Essentially, it would allow states to regulate their own industries without the fear of federal intervention.
Why make this move? More than anything, the States Act would open the door to basic banking services for the marijuana industry. If pot companies had access to checking accounts, lines of credit, and loans, they would be able to hire more workers, expand more quickly, reorder supplies with regularity, and move away from a reliance on cash, which is a security concern.
Gardner reintroduced the States Act on Monday, Dec. 17, as an amendment to the First Step Act, a criminal justice reform bill that has plenty of support on Capitol Hill and is widely expected to be signed into law. This is a bill that would reduce sentences for nonviolent offenders. By attaching it as an amendment to a larger, popular bill, Gardner hoped to change the way cannabis businesses seek financial services with ease.
Of course, the attached amendment needed to first get by Senate Majority Leader Mitch McConnell (R-Ky.). It failed to do so. Despite McConnell spearheading industrial hemp reform via the Farm Bill, which could become a major revenue driver within his home state of Kentucky, McConnell has shunned attempts to reform federal cannabis laws. Disallowing the attached amendment causes Gardner's second attempt to have the States Act signed into law to again come up short.
This isn't just a U.S. problem
Interestingly enough, gaining access to basic banking services isn't an issue confined to U.S. cannabis companies. Canadian marijuana stocks, which are now enjoying a fully legal environment, have at times still struggled to find financial institutions that are willing to provide nondilutive financing options.
Many have, in fact, still been turning to bought-deal offerings in recent months to raise capital. A bought-deal offering involves the sale of common stock, convertible debentures, stock options, and/or warrants in order to raise money. As a result of these actions, the outstanding share count of publicly traded companies increases, leading to share-based dilution and, often, a negative impact on earnings per share.
Perhaps the one exception to the rule has been the Bank of Montreal (NYSE:BMO). Back in February, Bank of Montreal co-led a round of financing totaling $136 million with GMP Securities for Canopy Growth. It was the first time a major bank had led a round of traditional financing for the marijuana industry.
Bank of Montreal has also actively lent money to Aurora Cannabis, the projected largest grower by peak annual production. In September, Aurora closed a 200-million-Canadian-dollar debt facility with Bank of Montreal that consists of a CA$150 million term loan and a CA$50 million revolving credit facility, both of which mature in 2021. Presumably, if the marijuana industry grows rapidly and starts raking in the green, financial institutions like the Bank of Montreal that are willing to give pot stocks a chance could share in that growth.
Even with adult-use pot legalized to our north, supply shortages, an increase in competition, and concerns about profitability have discouraged banks from offering a full complement of banking services to the cannabis industry.
Until this changes, the full potential of the marijuana industry may not be realized.