Canada Revenue Agency Penalties Highlight Black Market in Cannabis

When Canada legalized cannabis in October 2018, the expectation was that cannabis would be a significant revenue generator right out of the gate.

However, in the first year after legalization, the government took in $18 million in cannabis revenues, but had expected to take in $35 million. In 2020, the government expected it would bring in $100 million, but now projects federal tax revenues of only $66 million.

This shortfall was partially driven by the bumpy roll-out of legal cannabis, as well as the continued prevalence of illicit cannabis and an active black market in Canada. This was highlighted by a recent report stating that the Canada Revenue Agency (CRA) has levied over $1 million in penalties and fines since legalization started.

The existing black market is resilient

By legalizing cannabis in Canada, the goal was to move 100% of the then illicit market to the legal market. Estimates on the overall illicit market in Canada prior to 2018 range between $6-8 billion. The legal cannabis market in 2020 generated reported sales of $2.08 billion, which is respectable, but still means that $4-6 billion worth of cannabis is traded, sold and bought illegally.

One of the reasons for the lag in legal sales was the slow roll-out of legal cannabis in Canada. The rules and regulations were designed to ensure legal cannabis would not get into the hands of minors. As a result, retail stores in Ontario, for example, didn't open until April 2019 and, initially, the total number of outlets for the province was capped at 25. Stores in various provinces reported supply shortages.

This shortage in genuine legal supply was matched by the nearly unlimited illegal supply of the black market. In addition, black market sellers were offering the product for lower prices, partially driven by the avoidance of taxes. According to reports, black market dealers offer illegal cannabis for $6 per gram versus $10 for legal product.

To continue and accelerate the transition to a majority legal market, CRA has issued over $1 million in fines for the production and sale of illegal cannabis, since legalization started in October 2018. The nature of these fines is starting to highlight the challenges of the illegal cannabis market.

Penalties focused on legal supply chain

According to CRA, the agency has levied over two dozen penalties for violations of the Excise Act, which included one large fine of almost $500,000. The penalties were assessed for a variety of violations including:

• Production without an excise license

• Unaccounted-for excise stamps

• Inadequate books and records

• The purchase of cannabis by an excise licensee from an unlicensed person.

These penalties mirror illegal behavior in other excise tax markets, such as liquor and tobacco. As in other categories, licensing, record keeping, tax stamps and active, on-the-ground enforcement are all part of a comprehensive revenue authority enforcement program.

What is important to point out is that these fines appear to be levied mostly on the legal or licensed participants in the supply chain. That leaves significant enforcement opportunities against completely illegal, unlicensed and clandestine operations. The currently used tax stamp will be an important inspection and enforcement tool for these additional enforcement areas.

In addition, Health Canada has not levied any fines or penalties since legalization began but has instead focused on warning letters and license suspensions. Studies have shown that black market cannabis includes unapproved pesticides, increased heavy metals, foreign matter (eg. feces) and micro-organisms (eg. salmonella). Given the significant health risks illicit cannabis can pose, this will be an enforcement opportunity going forward.

What’s coming next – what is needed next

Despite the shortfall in tax collection in 2020, the federal Canadian government expects that tax collection will rise to $135 million in 2021 and steadily rise to $220 million by 2023, which will start to get projections back on track.

It is important to note that these revenue numbers only represent the federal portion of cannabis taxes. Provincial taxes make up the majority of cannabis taxes, with about 75% of tax revenue going to the provinces as part of a revenue-split deal agreed upon before legalization.

That equals about another $600-700 million on projected tax revenue for Canada’s provinces. By 2024, cannabis tax revenue at the federal and state level is going to approach close to one billion dollars, which will be a billion reasons why criminals will try to evade taxes by under-declaring, misreporting, illegal growing and smuggling.

Canada will need to continue to execute a comprehensive ‘all of government’ strategy to move the remaining illicit market into the legal marketplace:

• Increased enforcement: with the majority of Canada’s market still illicit, CRA will need to increase its enforcement to root out illegal participants, while ensuring comprehensive compliance by registered and licensed participants.

• Increased access: the black market thrives on scarcity. Increasing dispensaries, licenses and legal participants will help improve the convenience of buying legal cannabis rather than illegal product. Ontario for example now has 430 licensed retail locations, with 940 applications pending, and is approving 120 licenses per month.

• Limited tax increases: cannabis taxes are a tempting revenue source for governments, but the Canadian government will be well advised to hold steady on cannabis taxation until the majority of the market is legalized. Price differences are a significant driver of black markets and significant or sudden tax increases worsen these differences.

• Expansion of technology tools: CRA is already using tax stamps, but currently tax stamps are only associated to the entity which orders the stamp, and there is no traceability on what the stamp is being placed on. This unit level track and trace capability could be an important addition to CRA’s efforts.

• Continued leverage of tax stamp technology: Non-application of tax stamps, or even minor infractions like lost tax stamps, can carry significant fines and provide an effective deterrent. CRA’s fine structure provides a good indicator that tax stamps are an important tool in any comprehensive enforcement strategy and should be leveraged to identify illegal, unlicensed and clandestine operations.

• Increased penalties and fines: Health Canada has yet to issue fines or penalties. Given the increased health risks illicit cannabis can pose, penalties for non-compliance will add an important deterrent.

Cannabis legalization continues to provide a tremendous opportunity for governments to unlock untapped tax revenue, while moving an entire black market into the legal economy. However, it also provides a significant challenge, since the criminal market will do almost anything to hold on to its revenue.

Comprehensive ‘all of government’ approaches, incorporating reasonable licensing, moderate taxes, robust technology and significant enforcement efforts, will be needed to counteract the criminal market forces working to keep cannabis in the shadows.

Finally, effective excise tax payment verification, consumer authentication and diversion suppression will be an integral part of these legalization efforts across the globe. Providers that embrace these new markets with purpose-built and innovative technologies to assist enforcement and aid the transition to a legalized market, will unlock lucrative opportunities for years to come.

Sven Bergmann is the founder and CEO of Venture Global and advises brand owners, technology providers and governments on anti-counterfeit strategies, programs and technologies. Send your comments to [email protected].