Because of these newly tightened conditions, companies may face challenges when raising capital, forcing them to adopt a more thoughtful approach to seek funding. Likewise, investors will want to ensure their priorities are protected and their returns met. The combination of a given borrower’s need for capital and a financer’s desire to seek favorable returns may lead to the creation of agreements that have characteristics of both debt and equity. As such, it is crucial for all parties involved to understand the resulting tax classification and the treatment of these arrangements, so all expectations are met.

The taxation of debt and equity

For borrowers, the difference between debt and equity can be critical because interest payments are generally tax deductible and subject to certain limitations. Dividends or other payments related to equity would not be deductible for U.S. federal income tax purposes.

Enacted as part of the Tax Cuts and Job Act (TCJA) of 2017, one main limit on interest deductibility is the IRC 163(j) limit on the amount of business interest that can be deducted each year. This limit is calculated as 30 percent of adjusted taxable income, which prior to the 2022 tax year closely resembled earnings before interest, taxes, depreciation, and amortization (EBITDA). However, starting with the 2022 tax year adjusted taxable income excludes depreciation and amortization, becoming EBIT. This should result in a lower limit on the amount of interest expense that can be deducted each year. Any interest expense exceeding this annual limit can be carried forward to future years.

Determining if an arrangement is debt or equity for federal income tax purposes

Classifying an arrangement as debt or equity is made on a case-by-case basis depending on the facts and circumstances of a given agreement. While there is currently little guidance in this area beyond case law, the Internal Revenue Service (IRS) has issued a list of factors to consider when questioning whether something is debt or equity. (Keep in mind, however, that the IRS states not one factor is conclusive.) The factors include whether:

• An agreement contains an unconditional promise to pay a sum certain on demand or at maturity,
• A lender can enforce the payment of principal and interest by the borrower, and
• A borrower is thinly capitalized.

The courts have also established a broader — but similar — list of factors to consider when determining whether an instrument should be treated as debt or equity. Both the IRS and the courts have generally placed more weight on whether an instrument provides for the rights and remedies of a creditor, whether the parties intend to establish a debtor-creditor relationship, and if the intent is economically feasible. Some factors include:

• Participation in management (as a result of advances),
• Identity of interest between creditor and stockholder,
• Thinness of capital structure in relation to debt, and
• Ability of a corporation to obtain credit from outside sources.

For international companies, the characterization of debt or equity when considered in a cross-border funding arrangement is important, as withholding tax rates may apply to interest payments and may differ from tax rates applied to dividends. Further, withholding tax obligations occurs when a cash payment is made. If you have a cross-border arrangement, it is crucial to know if you have debt or equity on your hands.

Special rules related to payment-in-kind

Once it is determined that an agreement should be classified as debt for U.S. federal income tax purposes, some borrowers may prefer to set aside interest payments or pay interest with securities, which is often referred to as payment-in-kind (PIK). This is generally done to preserve cash flow for operations and growth of the business. When a borrower chooses this route, U.S. federal income tax rules will impute an interest payment to the lender.

While using a PIK mechanism will not automatically result in the debt being recharacterized as equity for federal income tax purposes, it can support viewing the instrument as equity.

Limits to deductible debt interest

There are limitations that can apply to interest deductibility. As noted above, IRC 163(j) limits deductibility of business interest; for a corporation, this is deemed to be all interest regardless of use. Another provision that can result in interest deductibility limitation is IRC 163(l), which applies to certain convertible notes and similar instruments held by corporations.

For cannabis operators, it is important to consider that IRC 280E disallows interest deductions. Hence, it is highly detrimental for cannabis operators to issue debt from entities that are cannabis plant-touching.

How we can help

Due to the nature of the debt versus equity analysis, companies thinking about fundraising should plan on how they intend to perform the raise and whether to have the raise treated as equity or debt. If debt classification is desired, a borrower should take the steps needed to strengthen the facts of the transaction to support the arrangement as a debt instrument.

MGO’s dedicated tax team has extensive experience advising companies across industries on capital-raising, debt refinancing and restructuring, recapitalizations, and other tax transactions. If you are planning to fundraise, or you are currently in the process of conducting a debt versus equity analysis, contact us today.

About the authors

Maryam Nicholes is a director and the national leader of MGO’s M&A Tax Advisory Services group. She has more than 13 years of experience advising on a wide range of clients, consulting on structuring and implementation of transactions including mergers, acquisitions and dispositions, global reorganizations, and new investment platforms. She also provides planning and related deal modeling regarding global cash tax exposures, repatriation planning, and related debt structuring and workout. Contact Maryam at MNicholes@mgocpa.com.

Matt Sapowith is a tax partner at MGO. He has more than 14 years of tax planning and compliance experience in areas including corporate and partnership taxation, international tax, M&A transaction advisory, transfer pricing, state and local tax, R&D credit, and compensation planning. He assists companies with structuring for multiple business lines, excise tax and sales tax planning and compliance in a variety of industries including technology, financial services, manufacturing and distribution, professional services, retail and consumer goods, cannabis, and cryptocurrency. Contact Matt at MSapowith@mgocpa.com.

Similar to the flurry of dotcom companies building out their platforms in the late 1990s, cannabis companies are investing vertically in order to provide seed-to-sale capability all under one roof. It’s this development, along with anticipated nationwide legalization, that is driving a number of mergers and acquisitions. Although there has been consolidation in prior years, 2019 is shaping up to be a bellwether, illustrating that the cannabis industry is preparing for a growth explosion.

The record-breaking start to 2019

So far in 2019, there have been several mergers and acquisitions worth billions of dollars. The action got an early start with two announcements in December of 2018; the MedMen acquisition of PharmaCann, and the purchase of a 45% stake in Cronos by Altria, the parent company of Phillip Morris USA. The MedMen-PharmaCann agreement included an all-stock transaction worth US$682 million and gave the combined company licenses to operate in 12 states with 79 cannabis facilities. The Altria-Cronos deal equates to US$1.8 billion for a 45% stake, with an option to purchase a majority stake in Cronos down the road.

In March of this year, Arizona-based Harvest Health & Recreation, announced it would purchase Chicago-based Verano Holdings, a vertically-integrated operator of licensed cannabis cultivation, manufacturing and retail facilities, for US$850 million.

More recently, in early April Cresco Labs agreed to purchase Origin House in an all-stock transaction valued at US$824 million. In late April, Canopy Growth Corp paid US$300 million for the right to merge with Acreage Holdings. Ontario-based Canopy Growth Corp, the first publicly traded cannabis company in North America, will purchase Acreage shares for US$3.4 billion, with full legalization acting as a triggering event for the complex merger deal.

In addition to mergers and acquisitions between cannabis companies, there is growing interest in cannabis from non-industry companies, such as alcohol, pharmaceutical, and tobacco – as illustrated by the Altria-Cronos announcement. Companies such as Constellation Brands, an international producer and marketer of beer, wine and spirits, paid $190 million for a stake in Canopy Growth Corp, hoping to counteract slowing beer sales and enter new cannabis-related markets.

What is driving cannabis M&A activity?

There are several factors motivating the increase in mergers and acquisitions in the cannabis space. Companies are seeking a variety of goals, such as a desire for vertical integration, an interest in operations in multiple states, and the aspiration by non-cannabis companies to enter the market. While these developments are worth noting, the trend is being driven by a much larger issue: the likelihood that cannabis use will be legalized nationwide by the US federal government. Investors and analysts believe this is more a case of when rather than if.

When legalization occurs and interstate restrictions are lifted, those companies maneuvering now will be well-positioned to effectively seize market share while others play catch up.

The US Congress, while not including language that would help resolve conflicting federal and state cannabis laws in pending criminal justice reform legislation, has left the door open to having a debate on nationwide legalization. “If there is an attempt to legalize across the country, we should have that debate and let the Congress decide the issue instead of creating a backdoor to legalization,” said Senator Chuck Grassley, the outgoing chairman of the Senate Judiciary Committee.

Forecasting beyond 2019

The wave of consolidation in 2019 is likely only the beginning. If a federal law is passed that legalizes cannabis, there will likely be a second wave of mergers and acquisitions with much higher stakes as the industry sorts itself out in in an effort to anticipate and fulfill coming demand.

In addition to consolidation, there will likely be a change to the banking industry in relation to doing business with cannabis companies. As of now, financial institutions are at risk of penalties, such as asset forfeiture and criminal fines, if they do business with companies in this space. In response to that risk, the House Financial Services Committee voted in favor of a bill protecting banks from federal punishment if they do business with such companies.

These moves signal a shift in how lawmakers are now viewing cannabis. If the federal government legalizes cannabis and financial institutions are allowed to engage those companies growing and selling it, then consolidation and investment in the near future could make 2019’s dazzling transactions look like chump change.

Similar to the flurry of dotcom companies building out their platforms in the late 1990s, cannabis companies are investing vertically in order to provide seed-to-sale capability all under one roof. It’s this development, along with anticipated nationwide legalization, that is driving a number of mergers and acquisitions. Although there has been consolidation in prior years, 2019 is shaping up to be a bellwether, illustrating that the cannabis industry is preparing for a growth explosion.

The Record Breaking Start to 2019

So far in 2019, there have been several mergers and acquisitions worth billions of dollars. The action got an early start with two announcements in December of 2018; the MedMen acquisition of PharmaCann, and the purchase of a 45% stake in Cronos by Altria, the parent company of Phillip Morris USA. The MedMen-PharmaCann agreement included an all-stock transaction worth US$682 million and gave the combined company licenses to operate in 12 states with 79 cannabis facilities. The Altria-Cronos deal equates to US$1.8 billion for a 45% stake, with an option to purchase a majority stake in Cronos down the road.

In March of this year, Arizona-based Harvest Health & Recreation, announced it would purchase Chicago-based Verano Holdings, a vertically-integrated operator of licensed cannabis cultivation, manufacturing and retail facilities, for US$850 million.

More recently, in early April Cresco Labs agreed to purchase Origin House in an all-stock transaction valued at US$824 million. In late April, Canopy Growth Corp paid US$300 million for the right to merge with Acreage Holdings. Ontario-based Canopy Growth Corp, the first publicly traded cannabis company in North America, will purchase Acreage shares for US$3.4 billion, with full legalization acting as a triggering event for the complex merger deal.

In addition to mergers and acquisitions between cannabis companies, there is growing interest in cannabis from non-industry companies, such as alcohol, pharmaceutical, and tobacco – as illustrated by the Altria-Cronos announcement. Companies such as Constellation Brands, an international producer and marketer of beer, wine and spirits, paid $190 million for a stake in Canopy Growth Corp, hoping to counteract slowing beer sales and enter new cannabis-related markets.