How the federal government has milked the cannabis business almost to death

A few weeks after Canada’s fifth anniversary of cannabis legalization, industry executives gathered in the Crystal Ballroom of the Omni King Edward Hotel in downtown Toronto.

They had travelled from across the country to attend the two-day, invite-only event, with tickets going for $1,800. Now in its third iteration, the room was humming a much different tune than it was in 2021, its inaugural year.

In 2023, just a few years removed from the pump-and-dump stock heights that saw some of the largest publicly traded companies’ valuations plummet by 99 per cent, the conversation is still centred around cash, but now it’s about how to find and preserve it.

“It’s very, very tough out there to raise capital right now,” said Darwin Fletcher, the event’s founder. “I think that’s one of the biggest challenges that people are facing.”

But it’s far from the only one. A half-decade into legalization — Prime Minister Justin Trudeau declared cannabis was legal as of Oct. 17, 2018 — the industry stands at an inflection point. On one hand, it has made substantial economic contributions — the sector’s GDP contributions are on par with the dairy industry — and it has carved out a global footprint, particularly in the growing medical cannabis export market.

On the other, it is grappling with financial strains, the need for clearer advocacy and education, and a regulatory framework that has been stuck in a state of inertia for years.

One of the conversations happening on the 14th floor of the hotel is a topic that has implications that extend far beyond the walls of the room — the sector’s onerous excise tax.

The back-of-the-napkin calculation is out of line with the realities of the industry, critics say, impacting not only the large corporate behemoths but also the numerous mid and small-scale businesses that make up the majority of the sector.

Although other long-standing industry concerns, like the 10mg THC edible limit and regulatory fees, are also regularly raised, opposition to the excise tax seems to be a rare unifying factor in an otherwise wildly complex and varied industry.

On average, the excise tax generates close to $1.5 billion annually for the federal, provincial and municipal governments.

“Everybody can say the excise is too high because it unequivocally is,” Barry Katzman, CEO of Peak Processing, a manufacturer of cannabis-infused beverages, told the room during a panel discussion. “The excise model was formulated based on $10 a gram and they haven’t altered it yet,” he added, as those in attendance nodded along.

Everybody can say the excise is too high because it unequivocally is

Barry Katzman

Under the excise structure, licensed producers are obligated to pay the tax when they package cannabis and related products for sale to provincially-approved distributors and retailers.

The tax was crafted by policymakers who erroneously forecasted that cannabis prices would stay around $10 a gram. In some instances, prices have compressed to little more than a dollar a gram, leaving razor-thin margins for producers, who say they are losing about 30 per cent of top-line revenue to excise. The fixed excise tax of $1 per gram of dried flower does not scale up and down with the selling price.

In October, the Cannabis Council of Canada (C3) published survey data from 122 licensed producers across Canada. It revealed that respondents paid 20 to 35 per cent of their 2022 gross sales in excise taxes, with over 70 per cent noting an increase in this rate from 2021 to 2022.

“This is unsustainable, not to mention illogical as it’s based on a price-per-gram formula, and prices have been steadily compressing,” they said.

The cannabis industry is also subject to a unique regulatory fee structure, which is not currently mirrored in the tobacco and alcohol sectors.

According to figures from C3, Health Canada collected about $75.7 million from its 2.3 per cent regulatory fee from cannabis companies in the fiscal year 2020-2021, and collected exactly zero in regulatory fees from tobacco or alcohol ventures across the same period.

But it’s not just the large-scale producers who are reeling from the excise tax and other regulatory missteps. Consumers pay a price, too.

Earlier this year, a report from Ernst & Young found that nearly 50 per cent of the price of a basket of legal cannabis products is due to government taxes and provincial markups. According to that report, the price of legal cannabis in Ontario is dictated by the original cost from the producer (27.1 per cent), the markup from the provincial distributor (18.8 per cent), the retail markup (26.3 per cent) and government taxes (27.8 per cent).

Everyone’s waking up and realizing that the government can’t just keep milking it

Owen Allerton, CEO of Highland Cannabis in Kitchener, Ont., a retail store, is involved in a new initiative from retailers aimed at educating consumers on the tax structure by placing stickers at the checkout with a breakdown of the prices,  illustrating how much tax is included. He says it’s akin to the stickers found on gas pumps.

A former director at BlackBerry, Allerton opened Highland in 2021. He entered the regulated sector with an expectation that it would “operate like a legal industry.”

“Everyone’s waking up and realizing that the government can’t just keep milking it,” he said.

“There’s a significant portion of the population that cares about this industry and about these products. And for the government to be completely turning a blind eye to it is a huge misstep, because I do think this is going to blow up in their face as the industry suffers. And as we all become aware of how it works, and start communicating and sharing this with our customers.”

Allerton said if the government is hesitant to make large-scale regulatory changes, it should at least introduce a tier for micro and craft growers that offers more relief and encourages small and independent businesses.

One of the small and independent businesses recently impacted by Canada’s regulatory framework is Fritz’s Cannabis Company, which operated as a grey market cannabis brand before joining the regulated industry in 2021. The brand was beloved within the cannabis community for its fierce independence and small-batch, handmade edibles.

The brand could recently be seen in ads from the Ontario Cannabis Store, with a focus on its entrepreneurship, a campaign that the husband and wife behind the brand say was at odds with the realities of working within the sector.

“We essentially folded last month,” co-founder Ari Cohen told National Post in October. “It was kind of a long time coming. So much was stacked against us, based on the regulations, based on (Ontario Cannabis Store) royalties, and the restrictions on what we could market and what we couldn’t. We just got pushed out of the market.”

Despite four years of being in the black — the OCS banked $459 million in the last fiscal year — the entity has not paid any dividends to the Ontario government. Of that $459 million, $310 million was excise tax and $148 million was sales tax.

Further complicating matters, the OCS markup is now 25 per cent and this markup is applied on top of the price of the product, which already includes the excise tax. Because the markup is a percentage added to the total cost, it effectively increases the impact of the excise tax.

Tabitha Fritz, the other founder of the brand, was featured on the OCS’s website in a roundup of small businesses that had made the jump from legacy to legal, but she said the support for their business stopped there.

“Within a week they told us they’re not picking up any of our products for the website. They literally said you’re not big enough for us to support you,” she said.

For its part, the government has repeatedly stated the industry is not about generating revenue, but about fixing a failed policy and protecting public health. What they missed, in Fritz’s opinion, is that those aspects are inextricably linked.

“It’s really just basic economics,” she said. “Until Health Canada addresses issues like edibles dosing and making sure budtenders are safe by not having coverings on windows, basic things like this, we’re going to continue to have two markets for weed. We’re going to have a regulated market and we’re going to have an underground market where consumers continue to access products that they want at prices that make sense. Until these things are addressed, you’re not actually addressing public health and safety, and you’re not meeting the claims of the Cannabis Act like you said you were trying to.”

In 2017, the Department of Finance published a backgrounder on the federal, provincial and territorial agreement on the cannabis taxation scheme.

Its first general principle notes that “taxes on cannabis will be kept low to support the objectives of its legalization: keeping it out of the hands of youth, and profits out of the hands of criminals.”

It went on to explain that taxes collected would largely be allocated to provincial and territorial governments, while 25 per cent would be directed to the federal government. It also noted that the federal portion of cannabis excise tax revenue would be capped at $100 million annually.

This year, though, the federal government’s share of excise taxes and estimated sales tax from cannabis sales are expected to exceed $455 million.

Beyond those coffers being stuffed far beyond what was initially planned, there’s also frustration within the industry as it’s not clear where that money, which should have tangible benefits for Canadians, is ending up.

David Brown, a cannabis industry policy analyst, was initially skeptical regarding corporate grievances about the excise tax but he also sees it playing out with the smaller producers. After accounting for the government’s take, some of these mid- and small-scale businesses barely manage to cover payroll and expenses, leaving no room for profit.

“A lot of small businesses haven’t been able to cut through that noise. And policymakers aren’t going to put their neck out on something where the public perception is entirely different. So, in my opinion, the industry needs to show that it’s a bunch of small businesses, they need to be able to tell the story of the struggling small craft farmer, the struggling independent retailer, as opposed to a struggling publicly traded company with all kinds of handsomely compensated C-suite executives.”

He added that the excise tax being built around the $10 a gram assumption is one of the “biggest errors in the legislation.”

He also said that over-regulation was initially understandable as Canada was the first G7 country to legalize the plant but, five years later, any anticipated calamities haven’t come to pass and it’s time to adjust.

Canada’s experience with cannabis regulation is becoming part of a larger global story. To escape the excise, Canadian companies are increasingly turning to the global export market, where Germany, Australia and Israel, among other countries, are taking on more Canadian products.

Germany, in particular, is at a pivotal moment, as its Cannabis Act is currently progressing through the German Parliament.

In January, “Pillar 1” of Germany’s cannabis strategy is anticipated to become law. The new legislation will remove cannabis from the Narcotics Act, allow for possession of up to 25 grams for adults, enable home cultivation of up to three plants and foster the establishment of not-for-profit cannabis cultivation clubs.

I think that Germany, and all of Europe, is the next big thing when it comes to cannabis

Niklas Kouparanis, co-founder of a German cannabis company

Niklas Kouparanis, CEO and co-founder of Bloomwell Group, one of Germany’s largest private cannabis companies, said the country is taking a conservative approach after watching Canada’s foray into legalization.

He said the focus on large-scale production of cannabis that far exceeded market demand, along with faulty distribution channels, are partly to blame for the more than 1.5 billion grams in unsold cannabis that’s accumulated across the Canadian sector.

“If the Canadian companies, or at least what is left of them, do not position themselves and form reliable long-term partnerships in Germany, then there will be no future for them. I think that Germany, and all of Europe, is the next big thing when it comes to cannabis.”

Back in the Crystal Ballroom in downtown Toronto, industry executives are taking a long view of the sector from the 14th floor.

Despite the frustrations and complaints, there’s palpable pride in the room as the conversation focuses on the strides Canada has made as the first industry of its kind in the world.

There have been missteps, many of them, but there’s a call for collective unity and a belief that, with time and regulatory evolution, a less volatile and more sustainable picture will take shape.

Fletcher reflected on the current state of the industry optimistically, crediting the people in the room around him. “The people that are still here in this room, they’re in for the long term,” he said. “They’re much more passionate about the industry and about the actual products versus just chasing a quick buck. I think, in 2021, we had a number of bankers, consultants and individuals who were just chasing a hot industry.”

Despite existing for just five years, the obituary of the industry has been written repeatedly as the focus has largely remained on the capital and equity markets.

Fletcher sees a different story, one that still has him brimming with optimism.

“It takes a long time to develop an industry, I think people forget that. And this is not only a new industry, it’s a very novel industry and it’s still growing. Just from a human factor, the people have changed a lot. Now it’s focused on operational excellence. How do we save money? How do we get lean? And then, also, how do we make money?”