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Cannabis Regulatory Cost Recovery Models – Health Canada Submission by C15 Solutions, Inc. (“C15”)

August 8, 2018

Cannabis Legalization and Regulation Branch
Health Canada
Address Locator: 0602E
Ottawa, ON K1A 0K9
Email: Cannabis@canada.ca

Re: Proposed Approach to Cost Recovery for the Regulation of Cannabis: For Consultation
Re: Submission to Health Canada on the User Cost Recovery Proposal

Introduction

Thank you for the opportunity to provide our comments on the proposed approach to cost recovery for the regulation for cannabis. Health Canada has requested submissions on its proposal to recover the costs of the administration, inspection and compliance resources dedicated to the cannabis sector.

This submission relates solely to the “Annual Regulatory Fee” (“ARF”). We have no particular comments regarding the Security Screening Fee, the Import/Export Permit fee, the Application Screening Fee.

Preliminary Note Regarding the Quantum of the ARF

The ARF is stated to be cost based and fully recovered by 2020. The method of recovery for the ARF is to be based on an annual levy of 2.3% on the gross revenues of the largest capitalized producers and 1%, for smaller companies, set out as less than $1 million in revenues. The ARF is waived for producers that claim exclusive medical purpose production.

The ARF is ostensibly capped at $23,000 and $2,500, respectively, for large and small producers.1 If one takes the number of all licensed facilities (i.e. approximately 107) and assumed all were large with no medical purpose exemptions, this would generate less than $2,500,000 in cost recoveries per year. The forecasted eligible regulatory costs that Health Canada is trying to recover is close to $100 million per year.2 Obviously the ARF does very little to assist with cost recovery if it is capped at this rate, and we do not believe that the other proposed fees are being relied upon to recover the remaining $80 – $100M of costs.

Accordingly, we are assuming for purposes of this submission the $23,000 caps will not be implemented on a per-licensee basis, or that they will quickly be discarded in favour of an uncapped ARF, in order to recover the costs that Health Canada is forecasting.

Executive Summary

Our overall submission is that the proposed ARF is not fair to license holders and is in direct conflict with one of the government’s key policy objectives. The royalty on gross revenues will harm small producers more than large and will harm the ability of all producers, especially small ones, from accessing and developing lower debt costs of capital. It is also unfair to distinguish between medical and non-medical producers when both use the same services of Health Canada equally, and medical producers may use such services even more so. It is also unfair to charge the same fees to “good” users of Health Canada services as “bad” users (i.e., those who cost the system more money).

As a preliminary matter, we also query whether the cost recovery model is a good idea at all, at least in the first few years following legalization, given the government’s goals of keeping the price of legal cannabis competitive with the illegal market. We also propose a cost recovery fee that is fairer to licence holders, based on a “user pays” model, that should be workable for the government, based on precedents in other industries.

Cost Recovery Will Likely Raise Prices Above Illegal Market Prices

The Office of the Parliamentary Budget Officer report, Legalized Cannabis: Fiscal Considerations, Ottawa, Canada November 1, 2016,3 noted on page 2 in that “When legalization occurs, the government may have little fiscal space to apply tax without pushing the price of legal cannabis significantly above the illegal market price.” The summary concludes that excise taxes, alone, will push the price above the illicit price.

The government has not heretofore provided any advance notice that the costs of legalization would have to be borne by the industry, and it is surprising, given the government’s aims to keep cannabis prices competitive with the illicit market, that this new revenue shortfall is being foisted onto the licensed cannabis producers. We recommend that the government reconsider its policy of trying to recover these costs from the cannabis industry in the first place, given its overall goals of keeping the cost of legal cannabis lower than the illegal market price, at least for the first few years of legalization while the illegal market remains strong.

Attributes of A Fair Cost Recovery Policy

Assuming that a cost recovery program will be implemented, our submission regarding fairness is as follows.

In our submission, a fair cost recovery policy should meet the following goals, while still being efficient and effective from the perspective of government administration. In our submission, a “user pays” policy is more fair than an across-the-board, flat fee, for the following reasons:

1) A fair cost recovery policy should not, even indirectly or inadvertently, create or assist in creating a barrier for the sector participants in sourcing and raising lower cost capital. A user charge recovery levy should leave the capital markets in a neutral stance as to how and what debt/equity structures are used by the producers to fund growth;

2) A fair cost recovery policy should avoid “moral hazards”, “free riders”, and negative incentives. It is an economic tenet of cost recovery models that those industry players that may be poor at compliance and therefore require more inspections, more audits and greater compliance oversight should pay for the full and appropriate allocation of the costs of the regulatory services consumed;

3) A fair cost recovery policy should avoid tilting the playing field in favor of the larger capitalized producers since the regulator ought not, albeit inadvertently, assist in the formation of oligopolistic like industrial structures – the result being regulatory “capture”;

4) A fair cost recovery policy should avoid the appearance of a tax. It should rather have a strong nexus to recovering costs created by the market participants being regulated.

“Royalty Model” Is Additional Tax

The most common global precedent for the ARF is found in the mining and resource sector, as mineral royalties.4

Royalties originated in the mineral sector as payments to a sovereign or competent authority for the right to extract minerals owned by that sovereign or competent authority. The evolution now covers many royalty types from unit royalties, gross overriding royalties, net smelter returns royalties and other formats. The ARF is indistinguishable from a gross revenue mining royalty.

The cannabis sector is an agricultural industry which differs dramatically from the mining and resource sectors. Cannabis is not a depleting resource. Cannabis is not owned by a sovereign jurisdiction. The production of cannabis does not leave environmental damage and scars like mining does. Legalized cannabis prices will develop into a spot, forward and long-term contract price curves. There will be a pricing battle between the illegal market, illicit prices and the overall end price to the consumer.

A royalty on gross revenues is effectively another tax, in addition to the federal excise tax, imposed under non-tax legislation, by a non-taxing authority. A regulatory authority such as Health Canada should not be in the business of charging a tax, and make no mistake, the resource royalty model is a tax. It is defined as a tax in every mining jurisdiction in the world, including Canada. The intent of the government’s proposed model may be to apply a simple cost recovery formula that is easy to administer. But the method that has been arrived at is simply a tax, in which case, the government may as well simply raise the rate of the excise tax instead of administering multiple systems. The CRA is better equipped to collect taxes, and it is already charging taxes from the same licensed producers – if it is just a matter of raising more revenues, why not just raise the rate?

The answer is that a higher excise tax would result in higher prices across the board on all cannabis produced (we are ignoring the $23,000 caps for the reasons noted in the introduction). This outcome puts a key Government policy objective at great risk, namely, to keep the prices of cannabis competitive with the illicit market. But the royalty tax does exactly the same thing, plus the additional cost of having a different authority charge and administer the tax.

The AFR, absent its impossibly low caps, could be challenged by the private sector as being illegal for a non-taxing authority to levy a tax. There are Supreme Court of Canada decisions that could support this challenge.

Moral Hazards, Free Riders, and Incentives

In economic terms, the ARF should aspire to be neutral in its impact on the market and cannabis prices. A poorly complying producer that draws and uses up exceptional amounts of resources should have to pay for the use of regulatory resources. A single gross royalty on revenues allows some “good producers” to over-pay and some “bad producers” to under-pay. The proposed model lacks a nexus to actual cost recovery and merely averages out the regulatory costs of compliance and inspection over the entire sector. Two single flat charges based on capital size creates the moral hazard equivalent of a “free rider” problem in economic terms and a “negative incentive” for “good producers”. The current cost recovery proposal is easily seen to be an additional “tax” because it is not levied on an actual cost recovery model, per producer.

A methodology that specifically recovered, fully costed inspection and audit resources in the quantum that any one producer “used”, then this alone would not increase the overall cost curve of the entire industry.

It is not wise public policy to exempt pharmaceuticals from cost recovery fees and it should not be wise to do so who claim exclusive medical production status. If anything, medical claims should require more overview and compliance not less. These are for profit producers, who already have some margin advantage over non-medical producers who must sell through wholesale channels.

Economic efficiency would demand that each producer, no exemptions, pay exactly the costs that it creates for itself. For example, the costs and prices per gram of a bad producer might cost more if that producer could pass along the costs. The costs of a “good producers” would not increase as much, keeping the prices of good producers lower than “bad producers”. A direct nexus versus a general “royalty tax” on the entire industry would mitigate against price increases because of the cost recovery concept.

Capital Markets and Cost of Capital

Over the last few decades, the capital markets have been skewed towards according the lowest cost of capital and highest levels of liquidity to the largest capitalization companies, public or private. The proposed ARF recovery model exacerbates the difficulty of smaller producers attracting lower costs of capital. A blanket levy on gross revenues is better absorbed by the largest capitalized producers versus the smaller ones. It is a matter of common knowledge that the nascent cannabis sector needs to develop and attract lower cost debt capital and become less reliant on the public equity markets. The proposed ARF will be a royalty “tax” as viewed by the market. This common-sense observation can be uncovered by simply speaking with the banking sector. This, unintended fallout, from the proposed model will tilt the playing field further in favor of the larger capitalization companies. It is not a market neutral proposal, absent the $23,000/$2,500 cap.

In time, the ARF model will be a material impediment to the development of lower cost capital sources that the cannabis sector needs. A two-rate flat royalty revenue model is more unfair or inequitable, to the smaller producers, regardless of the quantum. The existence of this proposed model leads to three negative economic outcomes:

1) creates barriers to the market developing and attracting lower cost capital structures using debt capital;

2) unfairly and inequitably favors the larger capitalized producers, perhaps tilting the playing field and leading to claims of “regulatory capture”;5 and

3) is simply not neutral in its impact on the market by the cost recovery mechanism being unconnected to the actual costs that a producer “uses or consumes” from the regulator.

Lastly, a lower cost of capital assists the Government in having lower prices, over time, which then allows for more excise tax room, over time. This future taxation room depends entirely upon the illegal market and the illicit prices being squeezed either out or minimized in consumer buying behavior.

An Alternative: Full Cost Recovery Model

The Canadian Nuclear Safety Commission Cost Recovery Fees Regulation, part of the Nuclear Safety and Control Act, June 5, 2003 Part I has the following cost recovery model.

It defines “full cost” as the sum of the costs of the Commission’s direct regulatory activities and indirect regulatory activities, including salaries and benefits, rental of office accommodations, supplies and equipment, professional services, communications, travel and training.

It defines “direct regulatory activities” as those activities, such as assessing applications, issuing licenses and certificates, granting approvals and authorizations, verifying and enforcing compliance and providing information, products and services, that are required for the Commission to fulfill its regulatory responsibilities.

It then defines, “indirect regulatory activities” as those activities that are in support of direct regulatory activities, such as management, training, administration, human resources, finance, information technology services and the preparation of documents, including policies, standards, guides, procedures and notices.

The statute then speaks to the calculation in Section 4 as “calculate the estimated annual fee payable by an applicant or a licensee for that fiscal year using the estimated full cost of the regulatory activity plan”.

This model very clearly sets a strong nexus between the costs and “each” licensee. The fees charged are based on Formula Fees of base hours variable hours and fixed fees. There are Special Project Fees and ways to charge more, if the annual estimate was not enough to cover the full costs as applied to that private sector entity.

The benefits of this model versus the gross royalty “tax proxy” are obvious, clear and transparent. The only negative is the administration of this full cost recovery methodology appears to be more costly, however, full costs are recovered through this model. A direct nexus will not, by definition, increase the entire industry’s cost curves. A direct nexus enhances the Government’s policy objectives and allows for future excise tax room as the illegal market gets squeezed out in faster timeline than an instant price increase of 12.3% (i.e., excise tax plus royalty).

Conclusion

This submission requests the Health Canada and the Government to alter its proposed gross revenue royalty cost recovery model in favour of a user pays model for the following reasons:

1. It appears to be a “tax”, and it is less efficient than the taxes that are already being raised by the tax authorities. The links to mining and mineral gross revenue royalty taxes have been discussed herein.

2. It is contrary to stated Government objective of reducing the influence of the illegal market to impose an industry wide price increase of 2.3% across every gram of production.

3. Deloitte recently published a 2018 Cannabis Report, entitled “A society in transition, an industry ready to bloom”. Page 2 states, in part, “Current and likely consumers expect to pay slightly more for legal products, with the former saying they’re willing to pay 10 percent more.” A levy of 2.3%, increases the government cost on top of the legal industry cost curve by 12.3%.6

4. A gross royalty cost recovery effectively increases the costs of capital for smaller producers more than larger producers squeezing out the small good producers not the illegal producers.

5. A “true” full recovery cost model is not seen to be a “tax”. Its impact is not an immediate price increase for every gram of production. It will, if applied as suggested in this submission, increase the costs of “some” producers more than others, which is fair. The regulatory cost should be borne by the producers which take the most compliance and audit resources.

6. A “true” full recovery cost model reinforces the key government objectives behind the Cannabis Act (Canada).

There is a made in Canada full cost recovery methodology which has a direct nexus to the costs created by producers, as we noted, in the nuclear sector. This alternative model is economically efficient and is not in conflict with stated government objectives. If a cost recovery model is required, we submit that this model should be adopted.

Sincerely,

Scott Samuel, B.Comm, MBA, J.D., LL.M., C.Dir.
Founder & Chief Executive Officer
C15 Solutions, Inc.
www.c15solutions.com

Sources

1 https://www.canada.ca/en/health-canada/programs/consultation-proposed-approach-cost-recovery-cannabis/document.html, Table 3

2 https://www.canada.ca/en/health-canada/programs/consultation-proposed-approach-cost-recovery-cannabis/document.html, Table 2

3 https://www.pbo-dpb.gc.ca/web/default/files/Documents/Reports/2016/Legalized Cannabis/Legalized Canabis Fiscal Considerations_EN.pdf

4 https://siteresources.worldbank.org/INTOGMC/Resources/336099-1156955107170/miningroyaltiespublication.pdf, particularly Chapter 3, for an excellent overview regarding mineral royalties.

“Regulatory capture” is an economic term, which in this context means:
a) The time a regulator spends with large capitalization producers, in close contact and communication, leads to behavioral bias and policies that favour such larger entities;
b) The regulator is not incentivised to foster a perfectly competitive economic model, in the classical definition, but rather to have some competition between larger entities (while still remaining short of an monopolistic structure); and
c) Asymmetrical information flows can result in the regulator being “captured” by the larger cannabis producers if the policy objective to squeeze out the illegal market is to be an achievable one, because the regulator needs to implement policies that are easier for these producers to handle than smaller ones.

6 https://www2.deloitte.com/content/dam/Deloitte/ca/Documents/consulting/ca-cannabis-2018-report-en.PDF

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