Medical Marijuana Taxation Performance Audit

Dennis J. Gallagher Auditor

Office of the Auditor

Audit Services Division

City and County of Denver

MedicalMarijuanaTaxationPerformanceAudit

September2014

The Auditor of the City and County of Denver is independently elected by the citizens of Denver. He is responsible for examining and evaluating the operations of City agencies for the purpose of ensuring the proper and efficient use of City resources and providing other audit services and information to City Council, the Mayor and the public to improve all aspects of Denver’s government. He also chairs the City’s Audit Committee.

The Audit Committee is chaired by the Auditor and consists of seven members. The Audit Committee assists the Auditor in his oversight responsibilities of the integrity of the City’s finances and operations, including the integrity of the City’s financial statements. The Audit Committee is structured in a manner that ensures the independent oversight of City operations, thereby enhancing citizen confidence and avoiding any appearance of a conflict of interest.

Audit Committee

Dennis Gallagher, Chair Robert Bishop Maurice Goodgaine Jeffrey Hart Leslie Mitchell Timothy O’Brien, Vice-Chair Rudolfo Payan

Audit Staff

John Carlson, Deputy Director, JD, MBA, CIA, CRMA, CGAP Chris Wedor, Internal Audit Supervisor, MBA Katja Freeman, Lead Internal Auditor, MA, MELP Manijeh Taherynia, Senior Internal Auditor, CPA, CFE, CRMA Torry J. van Slyke, Senior Internal Auditor

You can obtain copies of this report by contacting us at:

Office of the Auditor 201 West Colfax Avenue, Department 705 Denver CO, 80202

(720) 913-5000 Fax (720) 913-5247

Or download and view an electronic copy by visiting our website at:

www.denvergov.org/auditor

To promote open, accountable, efficient and effective government by performing impartial reviews and other audit services that provide objective and useful information to improve decision making by management and the people.

We will monitor and report on recommendations and progress towards their implementation.

City and County of Denver 201 West Colfax Avenue, Department 705 Denver, Colorado 80202 720-913-5000 FAX 720-913-5247 www.denvergov.org/auditor


September 18, 2014 Steve Ellington, Financial Executive Treasury Division City and County of Denver Dear Mr. Ellington: Attached is our audit of the medical marijuana taxation process in the City and County of Denver. The purpose of the audit was to evaluate the adequacy of Treasury’s processes and controls pertaining to the administration, enforcement, and collection of taxes due from medical marijuana businesses operating within City. The regulation of this industry is important because we are one of the first cities in the nation to tackle this opportunity. Recently our Senators Udall and Bennet and Senators Cantwell and Murray of Washington wrote a letter to White House Chief of Staff Denis McDonough and Attorney General Eric Holder to call for “a clear, consistent and uniform interpretation and application” of federal drug laws in relation to activities in Colorado and Washington. As the industry scales, the regulations that impact the legal marijuana trade need to be clear, enforceable, and well controlled. Although the audit focuses on medical marijuana, our work showed that existing tax compliance risks and controls related to medical marijuana are very similar to those related to recreational (retail) marijuana due to the way these businesses operate. Additionally, my team’s examination revealed that Treasury treats the marijuana business as any other type of high risk business in the City rather than focusing on the unique nature of this business, specifically. This has exposed the City, from a strategic tax compliance planning prospective, to unnecessary financial risk. It is my deepest hope that Treasury will take a more proactive approach to ensuring that this new and unique business market will have risks properly identified and any internal control gaps mitigated. If you have any questions, please call Kip Memmott, Director of Audit Services, at 720-913-5000. Sincerely,




DJG/cw cc: Honorable Michael Hancock, Mayor

Honorable Members of City Council Members of Audit Committee Ms. Cary Kennedy, Deputy Mayor, Chief Financial Officer Ms. Janice Sinden, Chief of Staff Mr. David P. Edinger, Chief Performance Officer Ms. Beth Machann, Controller Mr. Scott Martinez, City Attorney Ms. Janna Young, City Council Executive Staff Director Mr. L. Michael Henry, Staff Director, Board of Ethics



City and County of Denver 201 West Colfax Avenue, Department 705 Denver, Colorado 80202 720-913-5000 FAX 720-913-5247 www.denvergov.org/auditor


AUDITOR’S REPORT

We have completed our audit of Medical Marijuana Taxation. The purpose of the audit was to evaluate the adequacy of the Treasury Division’s (Treasury’s) processes and controls pertaining to the administration, enforcement, and collection of taxes due from medical marijuana (MMJ) businesses operating within the City and County of Denver.

Although the team’s work focused on MMJ, existing tax compliance risks and controls related to MMJ are very similar to those related to recreational (retail) marijuana due to the way these businesses operate. Therefore, in the discussions related to the tax compliance risks and controls throughout this audit report, we may make references to both MMJ and retail marijuana.

This performance audit is authorized pursuant to the City and County of Denver Charter, Article V, Part 2, Section 1, General Powers and Duties of Auditor, and was conducted in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

Our audit found that Treasury has supplemented its standard tax compliance activities with additional efforts intended to mitigate some of the potential risks associated with taxing MMJ businesses. However, Treasury has not sufficiently addressed the unique challenges associated with tax collection from the MMJ industry, which was apparent in two areas. First, we found that the Citywide marijuana policy does not address tax collection and the importance of compliance enforcement. Second, Treasury has not gathered sufficient data to ensure that its current MMJ industry tax compliance program is adequately mitigating the unique tax risks of the industry.

We extend our appreciation to Steve Ellington, Bruce Moore, and the entire Treasury Division who assisted and cooperated with us during the audit.

Audit Services Division

Kip Memmott, MA, CGAP, CRMA

Director of Audit Services

For a complete copy of this report, visit www.denvergov.org/auditor Or Contact the Auditor’s Office at 720.913.5000

Background The Treasury Division within the

City’s Department of Finance collects,

records, and deposits all City and

County of Denver taxes and other

revenues. It is made up of two

sections: Tax Compliance and Motor

Vehicle. The Tax Compliance Section

is responsible for billing, collecting,

and payment processing, recording,

and reconciling all collected taxes.

Medical marijuana is subject to 7.62

percent Colorado combined sales tax.

Purpose The audit evaluated the adequacy of

Treasury’s processes and controls

pertaining to the administration,

enforcement, and collection of taxes

due from medical marijuana

businesses operating within the City

and County of Denver. Although the

audit focuses on medical marijuana,

our audit work showed that existing

tax compliance risks and controls

related to medical marijuana are very

similar to those related to

recreational (retail) marijuana.

Therefore, in the discussions related

to the tax compliance risks and

controls throughout this audit report,

we may make references to both

medical and retail marijuana.

City and County of Denver – Office of the Auditor Audit Services Division

REPORT HIGHLIGHTS

Medical Marijuana Taxation Performance Audit September 2014

The audit evaluated the adequacy of the Treasury Division’s processes and controls pertaining to the administration,

enforcement, and collection of taxes due from medical marijuana businesses.

Highlights

The audit found that the Treasury Division (Treasury) has supplemented its standard tax compliance activities with additional efforts intended to mitigate some of the potential risks associated with taxing medical marijuana (MMJ) businesses. However, Treasury has not sufficiently addressed the unique challenges associated with tax collection from the MMJ industry, which was apparent in two areas. First, we found that the Citywide marijuana policy does not address tax collection and the importance of compliance enforcement. Second, Treasury has not gathered sufficient data to ensure that its current MMJ industry tax compliance program is adequately mitigating the unique tax risks of the MMJ industry. Specifically, Treasury has not:

Gathered sufficient data through completion of its current audits of MMJ business to ensure that its current tax compliance program is working effectively to ensure tax compliance by the MMJ industry

Enhanced its taxpayer education efforts to ensure that MMJ businesses have the information they need to comply with tax regulations

Engaged in collaborative efforts with other jurisdictions as a means of assessing its performance in the area of MMJ tax collection and enforcement

Although the percentage of tax dollars from MMJ is small compared to the sum total of all the City’s tax revenue streams, the percentage will only grow as the retail marijuana industry becomes more established. Further, there is a significant public relations risk exposure to the City related to MMJ operations owing to the nascent and controversial nature of marijuana sales. Treasury should use its experience with the MMJ industry to proactively ensure that it is prepared to carry out its responsibilities for ensuring tax compliance by the retail marijuana industry.

TABLE OF CONTENTS

INTRODUCTION & BACKGROUND 1

SCOPE 6

OBJECTIVE 6

METHODOLOGY 6

FINDING 7

The Treasury Division Has Not Sufficiently Addressed the Unique Challenges of Tax Collection from the Medical Marijuana Industry 7

RECOMMENDATIONS 15

Other Pertinent Information 16

The Marijuana Industry Faces Barriers To Accessing Banking Services 16

APPENDIX A 27

Denver Tax Glossary 27

APPENDIX B 29

Other City Agencies with Marijuana-Related Duties 29

APPENDIX C 30

Treasury Collection Process 30

APPENDIX D 31

Treasury Audit Process 31

AGENCY RESPONSE 32

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OOffffiiccee ooff tthhee AAuuddiittoorr Office of the Auditor

INTRODUCTION & BACKGROUND Legalization of Medical Marijuana in Colorado

In November 2000, Colorado voters passed Amendment 20, a constitutional amendment that legalized the medical use of marijuana for patients diagnosed with certain debilitating medical conditions.1 After the amendment took effect in 2001, medical marijuana dispensaries began opening sporadically across the state. Although marijuana remains an illegal substance under federal law, as of now, twenty-two of the fifty U.S. states and Washington, D.C., have passed laws legalizing the medical use of marijuana.

In October 2009, the Obama administration established a policy that reduced the enforcement priority of federal criminal laws against those complying with state medical marijuana (MMJ) laws.2 In 2010, the City and the Colorado General Assembly passed laws to regulate the industry. As a result, the number of MMJ storefronts in Colorado—referred to as medical marijuana centers—increased. Currently, four categories of MMJ businesses operate in Colorado.3

Types of Medical Marijuana Businesses

Medical Marijuana Center – A medical marijuana center (center), also referred to as a dispensary, is a retail business that sells patients MMJ or products infused with MMJ, such as edible products, ointments, pills, and tinctures. State statute also allows centers to sell up to six immature MMJ plants to patients. In addition, a center may sell immature plants to a primary caregiver, another center, or an MMJ-infused products manufacturer.4

Optional Premises Cultivation – An optional premises cultivation (OPC) operation, also known as grow operation, is a facility that grows and cultivates MMJ plants. A grow operation may be physically located adjacent to a center with which it is affiliated, or it may be in a different location and operate independently from the affiliated center.

Medical Marijuana-Infused Products – A medical marijuana-infused products (MIP) business is a business that manufactures products infused with MMJ, such as food or pills, that allow patients to consume MMJ in ways other than by smoking it.

Medical Marijuana Tester – A newer type of MMJ business, a marijuana tester is a laboratory that tests and certifies the quality of MMJ and MIPs.

1 Amendment 20 was codified as Section 14 of Article XVIII of the Colorado Constitution. 2 The federal memo outlining this policy, dated October 19, 2009, was issued by David W. Ogden, then Deputy Attorney General, and is commonly referred to as the Ogden Memo. 3 We conducted an audit on Medical Marijuana Licensing in 2013, which provides comprehensive background information on Colorado’s medical marijuana industry located at: http://www.denvergov.org/Portals/741/documents/Audits. 4 C.R.S. § 12‐43.3‐402 (3).

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Governing Rules and Regulations

In response to the surge of MMJ centers in Colorado, in early 2010 the State of Colorado and the City started to establish a regulatory framework for MMJ. The following regulations govern the taxability of MMJ.

Colorado Medical Marijuana Code – Article 43.3 of Title 12 of the Colorado Revised Statutes contains provisions related to taxability of MMJ sales in accordance with the state rules pertaining to collection and enforcement of state administered sales and use tax.5 Pursuant to the authority granted by Article 43.3, the Colorado Department of Revenue’s Marijuana Enforcement Division (MED) has developed a set of rules, titled “Permanent Rules Related to the Colorado Medical Marijuana Code,” which provides detailed regulatory requirements for MMJ businesses including but not limited to collection and remittance of sales and use tax.6

Denver Medical Marijuana Code – Chapter 24, Article XII of the Denver Revised Municipal Code (D.R.M.C.) governs the City’s MMJ business licensing activities and has two provisions related to MMJ sales tax:

o It requires an MMJ sales tax license for issuance of an MMJ center’s business license.

o It requires a tax bond in the amount of $5,000 to protect the City from claims should an MMJ business fail to pay taxes due to the City.

MMJ centers are subject to sales, use, and occupational privilege tax in accordance with Chapter 53 of the D.R.M.C. Medical MIPs, OPCs, and marijuana testers are required to have use and occupational privilege tax accounts with the City and remit these taxes.7 Table 1 illustrates the number of MMJ businesses that have City tax accounts.

Table 1

Number of Medical Marijuana Businesses with Denver Tax Accounts by Business Type

Source: Treasury Division.

5 State sales and use tax provisions are codified in Article 26 of Title 39, Colorado Revised Statutes. 6 The Colorado Department of Revenue, Marijuana Enforcement Division, 1 C.C.R. § 212‐1. 7 See Appendix A for the definitions of the City’s sales, use, and occupational privilege taxes.

Business Type Number of Taxpayers

with Tax Accounts

Medical Marijuana Center 226Medical Optional Premises Cultivation 217Medical Marijana Infused Products 80Medical Marijuana Tester 3Total 526

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Marijuana Inventory Tracking System

Pursuant to the statutory authority granted by the Colorado Medical Marijuana Code, the MED has established a Marijuana Inventory Tracking Solution (MITS) system to allow the MED and the marijuana industry to jointly track and account for MMJ and MIP products from either the seed or immature plant stage until they are sold to a patient or destroyed. MITS is a web-based tool coupled with radio-frequency identification (RFID) technology that allows wireless non-contact use of radio-frequency electromagnetic fields to transfer data for the purpose of automatically identifying and tracking tags attached to objects.8 OPC facilities are required to attach an RFID-enabled tag either to the seed or immature plant with an individualized number, which will follow the MMJ through all phases of production and final sale to a patient.

The MED required an existing MMJ business to have an active and functional MITS account on or before December 31, 2013, or face losing the privileges of its business license. The MED has established the following two objectives for utilizing MITS:

1. To provide a platform for the MED to exchange information with and provide compliance notifications to the industry

2. To regulate, monitor, and track all MMJ and MIP products to eliminate diversion, inside and outside of the state, and to ensure that all marijuana grown, processed, sold, and disposed of in the MMJ market is accounted for transparently9

City Marijuana Policy Initiatives

Following the passage of Amendment 64 in November 2012, when Colorado voters legalized the usage of retail marijuana, the Mayor appointed an Executive Director of Marijuana Policy for the City and County of Denver in December 2013. This position is responsible for overseeing and coordinating all marijuana-related activities of various City agencies, employees, boards, and commissions and also for collaborating with other local, state, and federal offices.

A number of City agencies and units have roles and responsibilities for, or are involved in, the regulation of the marijuana industry in Denver. See Appendix B for a list of these agencies and units and a brief description of their marijuana-related activities.

Treasury Division

The Treasury Division (Treasury) within the City’s Department of Finance collects, records, and deposits all City and County of Denver taxes and other revenues. It is made up of two sections: Tax Compliance and Motor Vehicle. The Tax Compliance Section is responsible for billing, collecting, payment-processing, recording, and reconciling all collected taxes. Additionally, the Tax Compliance Section deposits all City taxes and other revenues into City bank accounts. The Motor Vehicle Section acts as an authorized

8 See 1 C.C.R. § 212‐1‐ M 309 ‐ Medical Marijuana Business: Marijuana Inventory Tracking Solution (MITS). 9 Ibid.

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agent of the State of Colorado for titling, registering, and licensing of vehicles for residents and businesses located in the City and County of Denver.10

The activities of the Tax Compliance Section are carried out by the following work units:

Payment Processing and Return Correction – These units process and reconcile tax payments and research and correct taxpayers’ errors on returns.

Taxpayer Service – Receives walk-in tax payments, registers excise tax accounts, issues tax licenses, mails property tax bills and excise tax returns, and responds to taxpayer inquiries

Collections – Collects delinquent taxes and ensures that businesses are licensed and set up for appropriate tax reporting accounts and provides taxpayer education

Audit – Conducts tax audits of businesses to ensure compliance with the City tax rules and regulations and collects unremitted taxes and provides taxpayer education

Special Accounts – Collects property tax related to local improvement and special assessment charges, delinquent real property tax, and sewer and storm drain liens. Additionally, this unit conducts the annual tax lien auction, processes property tax deed applications, and administers the City’s Payment to the Elderly and Disabled Program.

Asset Recovery – Makes collection efforts on debts and monies owed to other City agencies

The City’s general fund provides Treasury’s operating expenditures. For 2013, these expenditures amounted to more than $10 million.

Controls and Tools Used by the Tax Compliance Section

Sales, use, and occupational privilege taxes are self-reported taxes, meaning taxpayers file their tax returns and remit taxes due at the frequency required and determined in accordance with D.R.M.C. The Tax Compliance Section uses standard internal controls and tools for tax collection, enforcement, and education of all businesses and industries regardless of the type, including the following five compliance activities:

1. The Payment Processing and Return Correction Units identify mathematical errors on tax returns and determine any interest and penalty due on delinquent returns.

2. The Collections Unit has a team of fifteen Tax Revenue Agents (TRAs) responsible for enforcing business tax compliance and collecting delinquent taxes. TRAs also monitor any business movement into and out of their designated areas of the City.11

10 The Denver Auditor’s Office is currently conducting a performance audit of the Motor Vehicle Section of Treasury. 11 See Appendix C for a flow chart of the Treasury collection process.

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3. The Tax Compliance Audit Unit conducts tax audits of various businesses that are selected based on sampling methods or various risk factors identified by Audit Unit management and Audit staff members.12

4. Treasury has developed a number of Tax Rules, under the authority granted to the Chief Financial Officer by the D.R.M.C., that provide more detailed explanations of various sections of the D.R.M.C. and are used in the administration and enforcement of related D.R.M.C. provisions.

5. Treasury has developed a large number of tax guides to serve as quick references written in layman's terms on a variety of tax topics. Tax guides generally contain a brief description of the applicable law and may provide one or more examples of taxable or exempt transactions within that industry, and references to the relevant D.R.M.C. provisions.

Medical Marijuana Tax and Revenue

In accordance with the D.R.M.C., MMJ is subject to 7.62 percent Colorado combined sales tax consisting of 3.62 percent City and County of Denver tax, 2.9 percent state tax, and 1.1 percent Regional Transportation District and Cultural Facilities District taxes. Table 2 shows the revenue the City generated from MMJ for the years 2011 through 2013.

Table 2

Medical Marijuana Revenue for Denver, 2011-2013

Source: Treasury Division. * City sales tax licenses are valid for a two-year period beginning with even-numbered years. These fees are collected in December of the odd-numbered year preceding the beginning of the effective year. The first MMJ licenses were issued in 2011 for 2012, which did not require renewal until 2013 for 2014. Therefore, there was no license-related revenue in 2012.

12See Appendix D for the Treasury audit process map.

YearMedical Marijuana

TaxesMedical Marjuana

License Fees * Total2011 2,772,920.00$ 31,835.00$ 2,804,755.00$ 2012 4,535,322.00$ - 4,535,322.00$ 2013 6,859,348.00$ 25,525.00$ 6,884,873.00$ Total 14,167,590.00$ 57,360.00$ 14,224,950.00$

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SCOPE The audit evaluated the adequacy of Treasury’s processes and controls pertaining to the administration, enforcement, and collection of taxes due from MMJ businesses operating within the City and County of Denver. Although the audit focuses on MMJ, our audit work showed that existing tax compliance risks and controls related to MMJ are very similar to those related to recreational (retail) marijuana due to the way these businesses operate. Therefore, in the discussions related to the tax compliance risks and controls throughout this audit report, we may make references to both MMJ and retail marijuana.

OBJECTIVE The objective of the audit was to determine whether Treasury has adequate internal controls and process in place to:

Mitigate the unique risks associated with MMJ sales Ensure compliance with applicable tax rules by Denver MMJ operators and timely

and accurate collection of taxes due from these businesses Be strategically prepared for tax compliance by and potential future expansion

of the recreational (retail) marijuana industry

METHODOLOGY The audit utilized several methodologies to achieve the audit objectives. The evidence gathering techniques included, but were not limited to:

Reviewing applicable laws, rules, and regulations Reviewing Treasury’s internal policies and procedures applicable to MMJ taxation Gaining an understanding of Treasury’s internal controls applicable to MMJ tax

administration, enforcement, and collection Interviewing Treasury management and personnel Interviewing other City officials Reviewing relevant internal and external audits Obtaining an overview of Treasury’s tax system—GenTax—and its reporting

capabilities Reviewing various GenTax reports and evaluating existing controls as

documented in the system Conducting benchmarking interviews with other tax jurisdictions regarding

controls over MMJ tax administration, enforcement, and collection Reviewing Treasury’s audit staff annual performance evaluations Reviewing sales tax audit procedures and samples of sales tax audit work papers

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FINDING The Treasury Division Has Not Sufficiently Addressed the Unique Challenges of Tax Collection from the Medical Marijuana Industry

Our audit found that the Treasury Division (Treasury) has supplemented its standard tax compliance activities with additional efforts intended to mitigate some of the potential risks associated with taxing medical marijuana (MMJ) businesses. However, Treasury has not sufficiently addressed the unique challenges associated with tax collection from the MMJ industry, which was apparent in two areas. First, we found that the Citywide marijuana policy does not address Treasury’s duties regarding tax collection or the importance of tax compliance enforcement. We believe that Treasury should be more actively involved in establishing taxation as an integral part of the Citywide marijuana policy. Second, Treasury has not gathered sufficient data to ensure that its current MMJ industry tax compliance program is adequately mitigating the unique tax risks of the industry. Specifically, Treasury should expedite its audits of MMJ businesses and could enhance its taxpayer education efforts to ensure that MMJ businesses have the information they need to comply. Finally, Treasury should increase its collaborative efforts with other jurisdictions as a means of assessing its performance in the area of MMJ tax collection and enforcement.

Although the percentage of tax dollars from MMJ is minimal compared to the sum total of all the City’s tax revenue streams, the percentage will only grow as the recreational (retail) marijuana industry becomes established. Additionally, there is a significant public relations risk exposure to the City related to MMJ operations owing to the “newness” and controversial nature of emergent public policy related to both medicinal and recreational marijuana sales. Treasury should use its experience with the MMJ industry to proactively ensure that it is prepared to carry out its responsibilities for ensuring tax compliance by the retail marijuana industry.

The City’s Marijuana Policy Does Not Include Tax Compliance Enforcement Provisions

Tax revenue from marijuana sales in the City and County of Denver is the primary funding source for the regulatory structure and related activities necessary for the City to mitigate marijuana-related risks associated with safety, health, and quality of life. Treasury is responsible for the collection of such tax revenues, the creation of tax policies and the enforcement of City tax rules; therefore, Treasury should directly insert itself to its fullest ability in the policy development process, and address tax compliance in the City’s marijuana policy.

The City’s Executive Director of Marijuana Policy (EDMP) formed a Marijuana Advisory Committee (MAC) to establish Citywide strategic marijuana policy.13 The MAC consists of

13 The Executive Director of Marijuana Policy is the mayoral appointee responsible for recommending, administering, and implementing the City’s marijuana policy goals, objectives, and priorities and acting as a liaison between the City and other

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the heads of relevant City agencies and key staff members, and its role is to guide the development of policies, procedures, business processes, and structural organization related to the sale of medical and retail marijuana in Denver. The MAC recommended three goals for the City’s marijuana policy:

Goal 1: Develop Comprehensive Marijuana Regulations

Goal 2: Enforce Marijuana Regulations Efficiently and Effectively

Goal 3: Protect the Health and Safety of the Community through Marijuana Education and Outreach

To implement these goals, a work program has been developed under the leadership of the EDMP. However, our review of the work program—and more specifically of the action items designed to achieve the enforcement provisions of Goal 2—determined that the program does not include a review of the enforcement tools available for achieving compliance with the City’s tax regulations. Without addressing the importance of MMJ tax collection and compliance enforcement, the City cannot ensure that Treasury’s enforcement tools are effective for achieving tax compliance by MMJ businesses.

Although Treasury does have representation on the MAC, Treasury should take on a more active role in the City’s strategic planning for marijuana policy that has been initiated by the EDMP. Specifically, Treasury should ensure that the review of City tax compliance is one of the steps toward achieving the strategic goal of efficient and effective enforcement of MMJ regulation.

Treasury Has Not Collected Sufficient Data Showing Whether its Current Compliance Activities Adequately Address the Unique Risks of the Medical Marijuana Industry

The unique nature of the MMJ industry creates equally unique challenges for tax collection and auditing. Treasury management asserts that they have adopted an adequate and cost-effective approach to ensure tax compliance by the MMJ industry. However, we found that its efforts could be supplemented in several areas, including prioritizing the auditing of MMJ businesses and providing better information to MMJ businesses regarding tax compliance.

Unique Medical Marijuana Industry Tax Compliance Risk Areas – Two characteristics of MMJ business operations put the City at risk for not collecting all tax revenue:

governmental agencies and institutional partners on marijuana issues and policies. The Introduction and Background of this report contains information about this initiative.

TheCity’smarijuanapolicyworkprogramdoesnotincludeareviewofthe

enforcementtoolsavailableforachievingcompliance

withtheCity’staxregulations.

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Cash Transactions – MMJ business transactions are generally made in cash, due to rigorous federal restrictions on what kind of businesses may use banking services. The cash-intensive nature of MMJ operations increases the risk of underreported sales and, consequently, underreported sales tax. The barriers MMJ businesses face with regard to accessing banking services are discussed in more detail in the Other Pertinent Information section of this report.

Inventory – MMJ businesses grow their inventory in-house, making it difficult for auditors to draw a link between sales and purchases for inventory. Although the State of Colorado has mandated the use of a Marijuana Inventory Tracking Solution (MITS) system for non-audit-related purposes, MITS data has not been used in any sales tax audits in Colorado and its usefulness for these types of audits has yet to be explored.14

In addition to these attributes, marijuana is different from the other types of businesses from which Treasury collects tax revenue in that its product is illegal at the federal level. Further, since marijuana is an emerging industry still in its infancy, it holds greater potential for unknown risks than would a more established industry.

Audit inquiries showed that Treasury has supplemented its standard tax compliance practices with several additional efforts intended to mitigate some of the potential risk associated with taxing MMJ businesses.15 Specifically, Treasury has reported that they have:

Placed MMJ businesses into a category of high-risk businesses that includes bars, liquor stores, and restaurants. As these are cash-intensive operations and volatile businesses, Treasury requires all businesses designated as high risk to file sales tax returns and remit sales tax due monthly, instead of quarterly or annually, regardless of the associated amount of tax liability.16

Reconciled MMJ tax account data with the licensure data from the Department of Excise and Licenses and the State of Colorado to ensure that MMJ businesses are licensed and being taxed accurately based on their business type17

Developed eleven reports in the Treasury tax system specific to the marijuana industry to review the industry tax data including, but not limited to, delinquency data

Developed additional tax audit procedures for cash-intensive MMJ businesses to mitigate the risk of underreported sales

Although these additional steps are appropriate and could serve to increase compliance by those in the MMJ industry, Treasury does not have sufficient data to show whether the controls adequately mitigate the risk of tax revenue loss due to the unique challenges that MMJ businesses pose. Treasury’s ability to tax a MMJ business is

14 For specific information about the primary objectives of using MITS, please refer to the Introduction and Background section of this report and http://www.mymits.com. 15 Treasury’s standard tax compliance program is described on pages 4 and 5 of this report. 16 Details of the filing frequency requirements can be found in the Department of Revenue, City and County of Denver Treasury Tax Rule TTR004. 17 The State of Colorado marijuana account list is public information and can be accessed at: www.colorado.gov/revenue/med.

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questionable if it cannot track the flow of the business’s money, since most marijuana-related businesses do not have bank accounts. Moreover, since Treasury chose to wait three years to start auditing MMJ businesses, the Tax Compliance section does not have sufficient data available at this point to assess whether their current tax auditing processes correctly address the risk of MMJ tax non-compliance.

Treasury Should Expedite Audits of Medical Marijuana Businesses

Our review determined that Treasury has begun a number of tax audits of MMJ businesses. However, those audits were not initiated until December 2013, three years after the MMJ industry opened its first operations in Colorado. Based on the unique nature of the MMJ industry and the importance of knowing whether or not current compliance tools are effective for these businesses, we believe that auditing should have commenced sooner.

Treasury management provided several reasons for deciding to wait for three years before starting their MMJ business audit activities:

1. The D.R.M.C. allows Treasury to audit a tax return for up to three years after the return is filed.18

2. Three years was sufficient time to generate enough tax records and more tax periods to audit, which would increase the cost effectiveness of the time and resources spent conducting the audits.

3. The MMJ industry was brand new and, particularly in the first year of operation as a regulated industry (2010), very volatile; MMJ businesses were coming into and going out of business quickly. Therefore, in Treasury’s view, it made sense to allow the industry to achieve some level of normalcy. According to Treasury management, although it is unusual for all businesses within an industry to be start-ups, it is a standard practice to wait three years before auditing a start-up business.

Other Jurisdictions Commenced MMJ Business Audits Earlier Than Treasury – The audit team contacted three other tax jurisdictions to determine whether other government entities had waited three years before commencing audits of MMJ operations. This benchmarking work revealed that two of the three jurisdictions initiated and completed MMJ audits earlier than Treasury. Specifically, the State of Colorado and the City of Boulder started their first rounds of MMJ tax audits in 2011 and completed those audits in 2012.19

18 D.R.M.C. Statute of limitations provisions Sec. 53‐68, Sec. 53‐136, Sec. 53‐272, Sec. 53‐324. In accordance with these provisions, any tax and applicable penalty and interest shall be assessed within three years after a tax return is filed. This time can only be extended if the taxpayer has signed a waiver or Treasury issued a notice of assessment for a tax deficiency within such period. 19 Colorado Department of Revenue, Marijuana Enforcement Division, http://www.colorado.gov/cs/Satellite/Rev‐MMJ/CBON/1251581331216 and City of Boulder, Tax and Licensing Division, https://bouldercolorado.gov/tax‐license.

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We compared Treasury’s reasoning for having waited three years against the regulations and operational policies relevant to the State of Colorado and the City of Boulder. We found that both jurisdictions must comply with similar statute of limitations requirements, and both regard cost-effectiveness as an important criterion in their audit practices. Further, both jurisdictions have been facing the same challenges with regard to the new and evolving MMJ industry. However, both the State of Colorado and the City of Boulder considered their audits of MMJ businesses a priority. The objective of these audits was to assess their jurisdiction’s risk for potential tax revenue loss associated with cash-intensive operations of MMJ businesses. The State of Colorado is currently conducting audits of retail marijuana and the City of Boulder will conduct retail audits in early 2015.

Audit inquiries further determined that not only has Treasury waited longer than the state and Boulder to conduct tax audits of MMJ businesses, but Treasury has not prioritized its current MMJ tax audits over the audits of other businesses, which would result in expedited completion. The main objectives of Treasury’s audit activities are to increase voluntary compliance and provide taxpayer education. By not prioritizing MMJ audits, Treasury is not meeting these objectives for the MMJ industry. Audit review of the status of the ongoing MMJ tax audits by Treasury showed:

Only three audits have been completed

Of the nine audits assigned to tax auditors in January and February 2014:

○ Seven have yet to be scheduled with the businesses being audited

○ Two are on hold, pending the delivery of records requested from the businesses being audited

It is crucial that Treasury expedite the completion of its ongoing MMJ industry audits, the findings of which will help Treasury determine whether additional action regarding Treasury tax compliance efforts is warranted, such as increasing marijuana-specific taxpayer education and expanding the number of MMJ audits conducted. These outcomes will also be important for consideration when planning for retail marijuana tax collection and compliance activities.

Treasury Should Enhance Taxpayer Education Efforts for Medical Marijuana Businesses

Our inquiries of Treasury management and review of the Treasury website revealed that Treasury has not developed any taxpayer information or educational material specific to the MMJ industry. Treasury management told auditors that this is because MMJ businesses are subject to the same taxes for which Treasury has already provided many general and non-industry-specific educational outreach channels, such as quarterly

Treasurywaitedthreeyearsaftertheindustrybegan

operatingtoinitiateauditsofmedicalmarijuana

businesses.

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training programs, tax guides, a simplified tax reference guide, online tax tutorials, and multiple tutorial options for Denver eBiz.20

Through our audit work, however, we determined that there is a need for some taxpayer educational information targeting the MMJ industry. In some instances, existing resources need to be updated to include MMJ businesses where appropriate. For example, Tax Guide no. 30, which addresses filing periods, notes the business types required to file tax

returns and remit taxes on a monthly basis. However, this note does not include MMJ businesses. In other instances, we found that new educational resources may need to be created. For example, after reviewing three of the Treasury MMJ tax audits that were completed, these audits showed that tax auditors identified several cases where the taxpayer, due to a lack of knowledge, had failed to charge Denver sales tax on certain

sales that are otherwise exempted from the state sales tax.21 As these audits are completed, Treasury might find more cases that require additional taxpayer education.

Through our benchmarking activities, we contacted the California State Board of Equalization (BOE), the public agency charged with tax administration and fee collection in the State of California. BOE personnel indicated that BOE first initiated a statewide education outreach effort in November of 2010 when every California MMJ business was contacted to ensure compliance and help businesses to file amended returns as needed. Based on the various risk factors identified during this outreach program, BOE selected some of these MMJ businesses to be audited.22

Tax outreach and education is an important characteristic of a business-friendly environment. During our research, auditors found a study by The Economist magazine that looked at the factors relevant to attracting businesses to an area.23 Third-party surveys of thousands of small businesses helped to determine that the ease of navigating a jurisdiction’s tax code and the educational tax material available are important factors for drawing businesses to a jurisdiction.

Additionally, on different occasions during the course of the audit, Treasury management noted that increasing voluntary compliance is an important goal of Treasury’s tax compliance efforts. To achieve this goal, it is important that Treasury pay closer attention to the specific needs of the emerging marijuana industry and develop industry-specific guidance in order to promote and facilitate voluntary compliance.

20 Denver eBiz is an online tool that allows taxpayers to file returns, make payment, file and pursue a claim for refund, and manage their accounts. 21 Colorado allows exemption of certain MMJ from state sales tax. However, the City tax rules do not recognize these exemptions. 22 The California BOE has a statute of limitations provision similar to Denver. “In general, for all taxpayers filing returns, other than those taxpayers who do not hold a permit and elect to report use tax on the California income tax return, the statute of limitations is three years. However, for those taxpayers who fail to file returns, the statute of limitations is eight years.” California, State Board of Equalization, Audits, Publication 76, October 2013. 23 The best and worst states for small business, Red tape blues, The Economist, July 5, 2014.

Treasuryhasnotdevelopedanytaxpayerinformationoreducationalmaterialspecifictothemedicalmarijuana

industry.

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Treasury Should Continue Outreach to Other Tax Jurisdictions for Marijuana Tax Compliance Best Practices

Treasury’s interactions with other tax jurisdictions have been limited to outreach initiated by smaller Colorado tax jurisdictions seeking feedback from Treasury about how the City collects marijuana tax revenue. Treasury is a member of the sales tax administration group of the Colorado Municipal League (CML), which provides a central location for potential inter-jurisdictional interactions. Treasury management stated that discussions among CML members during regular meetings are about a variety of topics covering different industries but no discussions focus on sharing and collaborating on ideas about the MMJ or retail marijuana industry.

Our team obtained information indicating that there are some valid concerns about the risk of fraud associated with the marijuana industry.24 Considering that marijuana remains an illegal substance at the federal level and draws a lot of public attention to states like Colorado that are at the forefront of marijuana legalization, it is very important that Treasury acts more proactively in regard to improving the marijuana industry’s overall compliance with City tax rules. Specifically, Treasury should reach out to other tax jurisdictions such as the State of Colorado, other Colorado municipalities, and federal agencies like the Internal Revenue Service (IRS) to share ideas about the current risks and trends in the marijuana industry. Using this information, Treasury could then assess how its activities and controls compare to other jurisdictions and how they could be enhanced.

One challenge that requires the immediate attention of Treasury and other tax jurisdictions is comparing in-house-grown MMJ inventory to sales in order to increase the accuracy of reported sales and taxes. Audit research showed that marijuana is not the only industry that grows in-house inventory. For example, wineries grow vines for wine production, requiring inventory tracking systems, which can be used for reconciliation in IRS audits.25

Although the State of Colorado’s primary purpose for requiring the use of MITS was to track and ensure transparency in all marijuana grown, processed, sold, and disposed of, the usability of MITS information in reconciliation of inventory for sales tax audit purposes should be explored. Treasury should initiate outreach to the State of Colorado and other jurisdictions to share ideas about how to expand the possibilities offered by MITS, or other inventory tracking systems that are used by the marijuana industry, and discuss other opportunities to improve the industry’s overall tax compliance.

24 Due to the confidentiality of the information, the audit report cannot provide more detail about this information. 25 Internal Revenue Service, The Wine Industry Audit Technique Guide, March 2011, http://www.irs.gov/Businesses/Small‐Businesses‐&‐Self‐Employed/The‐Wine‐Industry‐Audit‐Technique‐Guide Accessed on July 21, 2014.

Treasuryhashadlimiteddiscussionswithothertaxjurisdictionsregardingrisksandtrendsinthemarijuanaindustrytoassesshowitsactivitiesandcontrolscould

beenhanced.

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Lessons from MMJ Apply to Future Retail Marijuana Industry Growth

Although the sale of MMJ is taxed at the City’s general tax rate of 3.62 percent and only produces a small percentage of the City’s total tax revenue, the industry presents the same tax compliance risks as the retail marijuana industry.26 The City taxes retail marijuana sales at 7.12 percent, which can be increased up to 15 percent in accordance with the D.R.M.C.27

The potential tax rate increase along with any potential industry expansion might generate a significantly larger amount of tax revenue for the City in the future. Table 3 shows retail marijuana tax revenue for the first quarter of 2014, three months after retail businesses started in Colorado, indicating a growth trend in the retail industry.

Table 3

Denver Retail Marijuana Revenue for the First Quarter 2014

Source: Treasury Division.

Therefore, a timely assessment of the controls surrounding MMJ tax compliance is critical to ensure the effectiveness of similar controls used for retail marijuana industry tax compliance.

26 Data received from Treasury showed that MMJ tax revenue in 2013 amounted to $6,884,873 which comprised one percent of the City total tax revenue of $670,636,756. 27 D.R.M.C. § 53‐85 imposes Denver sales tax at the rate of 7.12 percent, consisting of Denver general sales tax of 3.62 percent and a retail marijuana excise tax of 3.5 percent.

January February MarchAmount 616,283.00$ 606,123.00$ 754,522.00$

Pecent Growth Not Applicable -2% 24%

AlthoughMMJonlyproducesasmallpercentageoftheCity’stotaltaxrevenue,theadditionofretailmarijuanamay

generateasignificantlylargeramountoftaxrevenueforthe

Cityinthefuture.

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RECOMMENDATIONS We offer the following four recommendations to the Treasury Division (Treasury) to ensure a strategic approach to medical marijuana (MMJ) tax compliance, which will also have a direct and immediate impact on retail marijuana tax compliance.

1.1 Strategic Planning – Treasury should take on a more active role in the City’s strategic planning for marijuana policy. Specifically, Treasury should, in collaboration with the Office of the Chief Financial Officer, ensure that the review of City tax compliance is one of the steps toward achieving the strategic goal of efficient and effective enforcement of MMJ regulation.

1.2 Compliance Audits – Treasury should expedite the completion of its ongoing MMJ industry audits and determine whether additional action regarding Treasury’s tax compliance efforts is warranted, such as expanding the number of MMJ audits conducted.

1.3 Educational Outreach – Treasury should develop taxpayer information and educational material specific to the MMJ industry and disperse it as needed.

1.4 Inter-Agency Coordination – Treasury should initiate outreach to the State of Colorado and other tax jurisdictions to share information and ideas about the risks and trends associated with the MMJ industry. As part of this outreach, Treasury should explore the possibility of using the state-mandated marijuana inventory tracking system or other system for sales tax audit purposes.

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Other Pertinent Information The Marijuana Industry Faces Barriers To Accessing Banking Services

Although the City lacks the authority to address the issues raised in this Other Pertinent Information section regarding banking and the marijuana industry, the Auditor’s Office adheres to a citizen-centric philosophy and uses reports to inform the citizenry of critical risks within and threats to their community. The following informal section describes the issue of marijuana businesses seeking banking services and associated problems that became evident as we assessed the Treasury Division’s (Treasury’s) tax compliance processes.

Despite its federal illegality, marijuana has emerged as an industry in many states, whether through medical marijuana or more rarely through recreational marijuana. The regulatory disconnect between the states and the federal government has put banks in a defensive position when approached by these businesses. Federal guidance has not assuaged the banking industry’s fears. Many assert that legislation is the only way to provide financial services to marijuana businesses, which will also serve to mitigate some of the risk that this new industry may pose to the public.

The Emergence of the Marijuana Industry

The United States has experienced a shift in public attitude regarding the legalization of marijuana over the past forty years, as reflected in a recent Gallup poll. In 1969, 12 percent of people surveyed thought that marijuana should be legal. In 2013, that number had risen to 58 percent. When asked if the federal government should enforce federal anti-marijuana laws in the states that have decriminalized or legalized the use of marijuana, 64 percent thought that the federal government should not enforce these laws.28

Twenty-two states and the District of Columbia have legalized medical marijuana (MMJ). Numerous states have decriminalized the possession of small amounts of marijuana. Two states—Colorado and Washington—have legalized retail marijuana. With Colorado being the first state in the country to legalize retail marijuana, media and political pundits alike have taken great interest in the paradigm shift that is taking place here. Many stakeholders and citizens are following how the State of Colorado and the City and County of Denver, by virtue of being the largest city in the state, have approached creating a regulatory framework to govern this new industry. The legalization of MMJ and retail marijuana has brought on notable interest in related public policy implications.

28 Gallup, Inc. Survey on “Illegal Drugs,” http://www.gallup.com/poll/1657/illegal‐drugs.aspx.

Twenty‐twostatesandtheDistrictofColumbiahave

legalizedmedicalmarijuana;ColoradoandWashingtonhavelegalizedretail

marijuana.

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Now that the marijuana industry has emerged from an unregulated and previously unlawful market in Colorado, state and local government agencies are collecting taxes on marijuana sales and want to track sales to ensure accurate collection across the industry. However, doing this is difficult for several reasons. One fact is that certain marijuana businesses grow their own inventory, which makes reconciling sales with inventory for auditing and tax collection purposes particularly challenging. Another significant problem the nascent marijuana industry has been facing is the difficulties associated with accessing financial institutions to conduct business. Owners of marijuana-related businesses face significant obstacles in obtaining bank accounts and conduct a majority of their business transactions in cash. Because marijuana remains unlawful on the federal level, financial institutions are reluctant or unwilling to work with owners of marijuana-related businesses. As we discuss later, guidance from the U.S. Department of Justice (DOJ) and the Financial Crimes Enforcement Network (FinCen) over the last few years has not helped alleviate the concerns of financial institutions and has failed to provide more security to banks that are approached by business people working in the marijuana industry.

Exacerbating the legal status issue is the federal government’s classification of marijuana as a Schedule I drug. In 1970, Congress enacted the federal Controlled Substances Act (CSA), which categorized regulated drugs into one of five categories based on their potential for abuse.29 The most harmful drugs are categorized as Schedule I and the least harmful drugs are categorized as Schedule V. By placing all controlled substances into schedules, laws can reference schedules without having to name every drug that is included in a schedule. Based on current classifications by the federal Drug Enforcement Administration (DEA), marijuana is a Schedule I drug with no accepted medical use, and is thus in the same category as drugs such as heroin, LSD, and ecstasy.30 Cocaine and methamphetamines are considered Schedule II drugs with less potential for abuse than Schedule I drugs.

Currently, the federal Food and Drug Administration (FDA) is conducting an analysis at DEA’s request to determine whether marijuana should be re-classified from a Schedule I

29 Controlled Substances Act; 21 U.S.C § 801 et seq. 30 “Schedule I drugs, substances, or chemicals are defined as drugs with no currently accepted medical use and a high potential for abuse. Schedule I drugs are the most dangerous drugs of all the drug schedules with potentially severe psychological or physical dependence,” U.S. Drug Enforcement Administration, accessed on July 21, 2014, http://www.justice.gov/dea/druginfo/ds.shtml.

TheControlledSubstancesActprohibitsbanksfromdealingwithproceedsfromcontrolledsubstances.

MarijuanaisclassifiedasaScheduleIcontrolled

substancewithnoacceptedmedicaluse,placingitinthesamecategoryasdrugssuchasheroin,LSD,andecstasy.

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drug. FDA reviewed marijuana’s status in 2006 and 2011, both times advising that marijuana remain a Schedule I drug.31

Regardless of state law, the CSA prohibits everyone, including banks, from dealing with controlled substances or the proceeds from them, which also includes the cash used in marijuana transactions. As a result, financial institutions are held to a certain standard based on banking industry regulations, such as the Bank Secrecy Act (BSA), which requires banks to look for money-laundering violations in customers’ deposit accounts.32 Banks must report any financial transactions greater than $10,000 using a Currency Transaction Report (CTR) and should file a Suspicious Activity Report (SAR) with FinCen as necessary.

SARs contain information that can help the federal government discover individuals and groups engaged in fraud, terrorist financing, money laundering, and other crimes. Theoretically, banks commit money-laundering when accepting deposits from marijuana-related businesses.33 However, by filing a SAR the bank may implicate itself, and it may be interpreted as the financial institution knowing that it is money-laundering. The Know Your Customer doctrine asks banks to understand their customers’ businesses and activities and file SARs and CTRs when necessary. This even holds true when customers try to hide the nature of their business when opening a banking account or depositing money into a bank account.

Guidance from Federal Agencies Has Not Provided Assurance to Financial Institutions

Conducting business with marijuana-related businesses presents risks for financial institutions, which DOJ has tried to address in several memoranda, including the Ogden Memorandum in 2009, the Cole I Memorandum in 2011, the Cole II Memorandum in 2013, and the Cole III Memorandum in 2014.

Ogden Memorandum (2009) – While the distribution, possession, and use of marijuana continue to be federal offenses, the Ogden Memorandum for Selected United States Attorneys dated October 19, 2009, stated that federal prosecutors should not use their resources “on individuals whose actions are in clear and unambiguous compliance with existing state laws providing for the medical use of marijuana.”34 This language indicated that the federal government would not prosecute patients and made it a low priority for law enforcement and prosecutors. However, it still left uncertainty with regard to marijuana-related businesses using financial institutions for their transactions.

31 Bloomberg News, “Marijuana Considered for Looser Restrictions by U.S. FDA,” accessed on July 21, 2014, http://www.bloomberg.com/news/2014‐06‐20/drug‐regulators‐study‐easing‐u‐s‐marijuana‐restrictions.html and DEA denied petition on July 8, 2011, Denial of Petition to Initiate Proceedings to Reschedule Marijuana, 76 Fed. Reg. 40,552 & 40,567. 32 Bank Secrecy Act, 31 U.S.C. 5311‐5330. 33 According to the U.S. Department of Treasury, “money laundering generally refers to financial transactions in which criminals, including terrorist organizations, attempt to disguise the proceeds, sources or nature of their illicit activities. Money laundering facilitates a broad range of serious underlying criminal offenses and ultimately threatens the integrity of the financial system,” http://www.treasury.gov/resource‐center/terrorist‐illicit‐finance/Pages/Money‐Laundering.aspx. 34 David W. Ogden, Deputy Attorney General, U.S. Department of Justice, Memorandum for Selected United States Attorneys, “Investigations and Prosecutions in States Authorizing the Medical Use of Marijuana,” October 19, 2009, http://www.justice.gov/opa/documents/medical‐marijuana.pdf.

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Cole I Memorandum (2011) – DOJ Deputy Attorney General James Cole changed course in the 2011 Cole Memorandum reconfirming that state-sponsored activities incorporating the production and dissemination of MMJ would remain a priority for federal law enforcement officials.

Persons who are in the business of cultivating, selling or distributing marijuana, and those who knowingly facilitate such activities, are in violation of the Controlled Substances Act, regardless of state law. Consistent with resource constraints and the discretion you may exercise in your district, such persons are subject to federal enforcement action, including potential prosecution. State laws or ordinances are not a defense to civil and criminal enforcement of federal law with respect to such conduct including enforcement of the CSA. Those who engage in transactions involving the proceeds of such activity may also be in violation of federal money laundering statutes and other federal financial laws.35

Cole II Memorandum (2013) – The second Cole Memorandum, dated August, 29, 2013, provides guidance for marijuana enforcement under the CSA. In the memorandum, Cole laid out eight priority enforcement areas.36

1. Preventing the distribution of marijuana to minors

2. Preventing revenue from the sale of marijuana from going to criminal enterprises, gangs, and cartels

3. Preventing the diversion of marijuana from states where it is legal under state law in some form to other states

4. Preventing state-authorized marijuana activity from being used as a cover or pretext for the trafficking of other illegal drugs or other illegal activity

5. Preventing violence and the use of firearms in the cultivation and distribution of marijuana

6. Preventing drugged driving and the exacerbation of other adverse public health consequences associated with marijuana use

7. Preventing the growing of marijuana on public lands and the attendant public safety and environmental dangers posed by marijuana production on public lands

8. Preventing marijuana possession or use on federal land

35 James M. Cole, Deputy Attorney General, U.S. Department of Justice, Memorandum for United States Attorneys, “Guidance Regarding the Ogden Memo in Jurisdictions Seeking to Authorize Marijuana for Medical Use,” June 29, 2011, http://www.justice.gov/oip/docs/dag‐guidance‐2011‐for‐medical‐marijuana‐use.pdf. 36 James M. Cole, Deputy Attorney General, U.S. Department of Justice, Memorandum for all United States Attorneys, “Guidance Regarding Marijuana Enforcement,” August 29, 2013, http://www.justice.gov/iso/opa/resources/3052013829132756857467.pdf.

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Cole III Memorandum (2014) – This memorandum from February 14, 2014, stated that the previous 2013 memo was issued in response to recent marijuana initiatives in certain states and applies to all DOJ marijuana enforcement nationwide. It did not, however, offer guidance on “what, if any impact the 2013 memo would have on certain financial crimes for which marijuana-related conduct is a predicate.”37 It reiterates that the provisions for money laundering and the BSA remain in effect and reminds financial institutions that conduct transactions with money from marijuana-related businesses are liable under the BSA. Prosecutors should enforce the eight enforcement priorities as described in the Cole II Memorandum from 2013. The 2014 memo points out that the 2013 guidance rests on the assumption that states authorizing marijuana-related conduct will implement robust regulatory and enforcement systems.38 While the DOJ states in this memo to be committed to using limited resources to pursue only the most significant marijuana-related cases, it does not provide protection from prosecution and still upholds the previous eight enforcement priorities.

Financial Crimes Enforcement Network Guidance – In February 2014, FinCen issued guidance to provide clarification regarding how to interpret BSA requirements for businesses wanting to provide banking services to marijuana-related businesses.39 This guidance was developed in response to some states legalizing MMJ and retail marijuana and DOJ issuing guidance concerning marijuana enforcement under the CSA. In assessing the risk of providing services to marijuana businesses, the FinCen guidance advises that a financial institution conduct customer due diligence that includes:

Verifying with the appropriate state authorities whether the business is duly licensed and registered

Reviewing the license application and related documentation submitted by the business for obtaining a state license to operate its marijuana-related business

Requesting from state licensing and enforcement authorities available information about the business and related parties

37 James M. Cole, Deputy Attorney General, U.S. Department of Justice, Memorandum for All United States Attorneys, “Guidance Regarding Marijuana Related Financial Crimes,” February 14, 2014, http://www.justice.gov/usao/waw/press/newsblog%20pdfs/DAG%20Memo%20‐%20Guidance%20Regarding%20Marijuana%20Related%20Financial%20Crimes%202%2014%2014%20(2).pdf. 38 Ibid. 39 Department of Treasury, Financial Crimes Enforcement Network, FIN ‐2014‐G001, Guidance: BSA Expectations Regarding Marijuana‐Related Businesses, February 14, 2014. The Bank Secrecy Act (BSA) “requires U.S. financial institutions to assist U.S. government agencies to detect and prevent money laundering. Specifically, the act requires financial institutions to keep records of cash purchases of negotiable instruments, file reports of cash transactions exceeding $10,000 (daily aggregate amount), and to report suspicious activity that might signify money laundering, tax evasion, or other criminal activity,” FinCen, http://www.fincen.gov/statutes_regs/bsa/.

DepartmentofJusticememosfrom2009,2011,2013,and2014havenotprovidedbankswithassurancethattheycanservethemarijuana

industrysafefromprosecution.

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Developing an understanding of the normal and expected activity for the business, including the types of products to be sold and the type of customers to be served (medical versus retail)

Ongoing monitoring for suspicious activity, including for any of the red flags described in the guidance

Updating information obtained as part of customer due diligence on a periodic basis and commensurate with the associated risk

The FinCen guidance further recommends that a financial institution examine, as part of its due diligence, whether a marijuana-related business follows the enforcement priorities as outlined in the Cole 2014 memo or is in violation of state law. This standard is important for a financial institution to consider when deciding whether to engage in a business relationship with a marijuana-related business.

In the event that a financial institution decides to accept a marijuana-related business as a client, the FinCen guidance recommends that the institution file a Marijuana Limited SAR. Financial institutions may use the state information they receive about the marijuana-related businesses, and the limited SAR should include the following information:

Identifying information of the subject and related parties

Addresses of the subject and related parties

The fact that the filing institution is filing the SAR solely because the subject is engaged in a marijuana-related business

The fact that no additional suspicious activity has been identified

The last point regarding suspicious activity is of particular interest, since it requires banks to conduct extensive background research to provide the necessary assurance. The guidance document lists several red flags that could indicate that a marijuana-related business is conducting activities in conflict with the Cole 2014 memo or in violation of state law. Among those red flags listed is that a business may receive substantially more revenue than its local competitors or than might be expected given the population demographics.40 The business may also deposit more cash than is commensurate with the amount of marijuana-related revenue it is reporting for federal and state revenue.

Regulators may revoke a bank’s Federal Deposit Insurance Corporation (FDIC) insurance if they detect that the bank is conducting business with an owner of a marijuana-related business.41 Therefore, the risks for banks and other financial institutions are too high compared to what they might gain by entering into a business relationship with marijuana-related businesses.

40 Ibid. at 5. 41 The FDIC is an independent agency of the U.S. government protecting against loss of deposit if a bank is FDIC insured. FDIC insurance covers all deposit accounts, including checking accounts, saving accounts, money market deposit accounts, and certificates of deposit.

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Legislative Initiatives to Facilitate Access to Banking Services for the Marijuana Industry

Several elected officials have attempted to address the challenges facing marijuana-related business owners seeking banking services. The following highlights some recent legislative initiatives that address the lack of access to the financial system:

Federal Initiatives

H.R. 2652, Marijuana Business Access to Banking Act of 2013, by U.S. Representative Perlmutter of Colorado and others seeks to prohibit federal prosecutors from punishing any bank servicing marijuana businesses in states that have legalized and regulated marijuana. The bill is currently headed to the U.S. Senate for consideration.

H.R. 5016, co-sponsored by Representative Perlmutter and three others, takes aim at the U.S. Department of Treasury’s oversight of banks by narrowing the scope of earlier directives the agency gave for banking with the marijuana trade. It is unclear when the issue will be taken up and whether the U.S. Senate will approve the bill.

H.R. 5106, which passed out of the House of Representatives in May, aims to restrict the DOJ and DEA from meddling with state-approved MMJ programs and is heading to the U.S. Senate for consideration.

Two U.S. Senators, Dianne Feinstein of California and Charles Grassley of Iowa, have challenged the U.S. Department of the Treasury’s guidelines, issued by FinCen, asserting that the action usurped federal law, which considers marijuana an illegal substance. They believe that only Congress can resolve this issue.

State Initiatives

Colorado House Bill 14-1398 addresses the fact that marijuana is illegal under federal law, and, thus, financial institutions are reluctant to serve state-licensed marijuana businesses owners or operators. The bill creates cannabis credit co-ops, which are subject to regulation by the State Commissioner of Financial Services in

a manner similar to that of credit unions, with some notable differences. On May 21, 2014, the state legislature sent the bill to the Governor, who signed the bill into law on June 6, 2014.

Colorado Senate Resolution 14-003 recognizes that the ability of the federal executive branch to facilitate a reasonable regulatory structure for the marijuana industry is limited, due to federal law categorizing

marijuana as an illegal substance. It proposes a solution to the problem of a lack of financial services for the legal marijuana industry by asking for comprehensive federal legislation authorizing banks and credit unions to serve the legal marijuana and hemp businesses.

Theriskforbankslikelyoutweighsthebenefitsoftakingonmarijuanaindustryclients.

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The Colorado Bankers Association Believes an Act of Congress is Necessary

The Colorado Bankers Association maintains that no bank can guarantee that a marijuana-related business is in compliance with every detail of the Cole II memo and the FinCen guidance.42 The Association further questions how the State of Colorado can accurately tax a business if it cannot track the flow of money, by virtue of the fact that most marijuana-related businesses do not have bank accounts. According to the opinion of the Colorado Bankers Association, a state-owned financial institution designed to circumvent illegalities on the federal level will not work because the very moment the state-owned bank would connect to the national payment system—through checks, automated teller machines, debit and credit cards, internet banking, or wire transfers—federal law would apply to these activities. Although the perspective of the Colorado Bankers Association is directed toward the state, the same logic can be applied to challenges facing the City and County of Denver. Hence, the view is that an act of Congress is necessary to change the current situation.

Few Examples Exist of Banks Accepting Marijuana Businesses as Clients

On the Colorado state level, H.B. 14-1398 authorizes marijuana financial service cooperatives. However, these cannabis credit co-ops as suggested in the bill are also subject to regulation by the State Commissioner of Financial Services in a manner similar to that of credit unions, with some important differences. In an interview with the Denver Post, the Marijuana Industry Group, a Colorado trade association, voiced the idea of establishing a grant to cover additional costs a bank incurs when dealing with marijuana businesses. The grant moneys would cover the added costs of hiring extra staff to conduct required work and legal fees to stay in compliance with demands of FinCen when dealing with marijuana businesses.43

In Nevada, First Security Bank of Nevada will offer accounts for MMJ businesses under the recent guidelines established by the federal government. The bank revealed that it will work with MMJ businesses because several of its “prominent clients” are applying for licenses to operate dispensaries and cultivation sites. Being public about having MMJ businesses as clients is highly unusual, as is the announcement by First Security Bank of

42 Don Childears, Financial Institutions Subsection Luncheon Series, “Banking or Marijuana Businesses: An Update,” Webcast, April 16, 2014. 43 Michael Elliott, interview by Jeremy Meyer, “Colorado’s roll‐out of recreational pot,” Denver Post, February 28, 2014, http://www.denverpost.com/Opinion/ci_25249447/Michael‐Elliott‐on‐Colorados‐rollout‐of.

ColoradoHouseBill14‐1398createscannabiscreditco‐opsandwassignedintolaw

inJune2014.

TheColoradoBankersAssociationmaintainsthatcannabiscreditco‐opswillnotworkbecausethe

momentonewouldconnecttothenationalpayment

system,theinstitutionwouldbeinviolationoffederallaw.

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Nevada; very few other banks have done the same. Colorado marijuana business owners have been quoted in newspaper articles as saying that some credit unions conduct business with them but, so far, no bank or credit union has admitted to that publicly. An example of MMJ businesses having access to financial institutions is Canada, since MMJ is legal on the federal level in Canada.

Marijuana Industry Supporters Believe in Great Gains from Legalization

Supporters of the marijuana industry make arguments for legalization based on financial and therapeutic reasons. They assert that legalization would help reduce government spending currently dedicated to enforcement costs. Moreover, an often mentioned argument of marijuana lobbyists is that annual tax revenues for governments could be increased through proposed taxation and regulation. Marijuana supporters also promote the therapeutic benefits for citizens using marijuana for medical purposes.

The Marijuana Industry Group has asserted that the industry should be taxed higher than other industries and was in favor of Colorado Proposition AA to increase excise and sales taxes.44 They argue that this money should then help to conduct additional unbiased research and educational programs. Marijuana industry supporters have also pointed out the fact that marijuana-related businesses face a variety of burdens that other business owners do not encounter, such as difficulties paying taxes electronically and getting penalized as is the case when paying federal taxes to the Internal Revenue Service (IRS). Currently, the IRS is assessing a 10-percent penalty on legal marijuana businesses that are forced to pay federal withholding taxes in cash; without a bank account, they cannot access the online payment system through the Automated Clearing House. Marijuana industry supporters are strong proponents of finding a solution to the banking issues the industry is experiencing.

Public Safety

The cash-heavy nature of marijuana businesses may make these businesses vulnerable to crime and pose a risk to public safety. Marijuana businesses that can afford the additional costs hire security companies to protect themselves from crime. There is conflicting information available about whether the legalization of MMJ leads to increased levels of crime. One study from the University of Texas Dallas claims that no correlation exists between MMJ legalization and crime increases, based on FBI Uniform Crime Report data that was used for the study. In fact, the study found slight decreases in some types of

44 Colorado Proposition AA, Retail Marijuana Taxes, appeared on the November 5, 2013 ballot in Colorado, http://www.sos.state.co.us/pubs/elections/Initiatives/titleBoard/results/2013‐2014/PropositionAAText.pdf.

Thecash‐heavynatureofmarijuanabusinessesmakethemvulnerabletocrime,

posingarisktopublicsafety.Notallcanaffordthe

additionalcostsassociatedwithhiringextrasecurity.

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violent crimes such as homicide and assault.45 In this study, data from 1990 to 2006 was used tracking crimes across all fifty states when eleven states had legalized MMJ. Activity within the MMJ industry in Colorado and other states, however, increased significantly in 2009. The Ogden memo provided more assurance to business owners operating MMJ facilities that if they were operating in compliance with existing state law, federal law enforcers would not focus federal resources on their activities. In 2010, the City and the Colorado General Assembly passed laws to regulate the industry. As a result, the number of MMJ storefronts in Colorado increased. With this in mind, the data in the study do not cover the time period from 2009 through today when the MMJ industry increased significantly.

Others have claimed that violent crime has been linked to the MMJ industry statewide.46 Data from the Colorado Department of Safety provided to the Denver Post noted a small increase in violent crimes in Denver near dispensaries in 2013 compared to 2012. This increase is in line with the slight increase in crime Citywide for that same time period.47 However, crime data for the first quarter of 2014 from the Denver Police Department show that violent crime, including homicide, sexual assault, robbery, and aggravated assault, fell by 6.9 percent compared to the same period in 2013.

The City has adopted a public policy position focused on ensuring public safety; the safety of children is especially of prime concern in the context of legalizing marijuana. Few studies exist analyzing the impact that medical and retail marijuana have had on crime levels; further research is necessary to make inferences about causation versus correlation. Policymakers need to have robust data to make sound improvements.

Marijuana Use Trends and Demand Estimates

Several studies have been undertaken attempting to assess use patterns among the population and compute future demand for marijuana. This type of data is necessary to make predictions about how the industry may grow or future revenue for governments. The Marijuana Market Study (2014) created by the Marijuana Policy Group for the Colorado Department of Revenue stated that in general, marijuana use in Colorado has increased continuously from 2004 to 2010.48 A recent revelation is that heavy users account for most of a region’s demand and that infrequent users have a very small

45 Robert Morris, Michael TenEyck, J. C. Barnes, Tomislav V. Kovandzic, “The Effect of Medical Marijuana Laws on Crime: Evidence from State Panel Data, 1990 – 2006,” http://www.plosone.org/article/info%3Adoi%2F10.1371%2Fjournal.pone.0092816. 46 Ibid. 47 John Ingold and Jeremy Meyer, “Slight increase in crimes near Denver medical‐marijuana dispensaries,” Denver Post, July 31, 2013, http://www.denverpost.com/ci_23771049/slight‐increase‐crimes‐near‐medical‐marijuana‐dispensaries. 48 The Marijuana Policy Group, Market Size and Demand for Marijuana in Colorado, 2014: 11, http://www.colorado.gov/cs/Satellite?blobcol=urldata&blobheadername1=Content‐Disposition&blobheadername2....

Fewrecentstudiesexisttodeterminewhetherthegrowthofthemarijuanaindustryhashadanimpact

oncrimerates.

P a g e 26


impact upon demand.49 The study estimates that the total resident and visitor demand of marijuana products for 2014 will be 130.3 metric tons.50 Compared to previous studies, this value is significantly higher. According to the study, this number is an estimate of projected demand for 2014 and does not speak to the availability of supply. The study further points out that there are approximately 149,000 marijuana users under the age of twenty-one who consume marijuana and do not have legal access to marijuana products unless they possess a medical marijuana card (red card).

To make projections for the future, it will be important to obtain additional data to understand the percentage of overall marijuana demand that home-grown marijuana represents. In the past, home-grown marijuana was illegal, and thus, surveys estimating the amount of home-grown marijuana might have been inaccurate due to under-reporting. A survey of marijuana consumption in the state of Washington has computed the percentage of home-grown marijuana to be 17 percent. If this same rationale were used, home production of marijuana would create 20.6 metric tons of the projected demand.51

Many Colorado residents, however, are owners of red cards, which enable them to purchase marijuana at a lower tax rate, which reduces the number of Coloradans purchasing retail marijuana. Another issue in developing accurate projections, the study points out, is the gray market created by MMJ users who legally obtain marijuana through their red cards and then sell the marijuana to others in Colorado or transport it out-of-state.

Lastly, the study mentions the difficulties in assessing the demands of the existing black market and how retail marijuana will affect the size of the black market.52 The authors of the study speculate that if retail prices stay as high as they were in early 2014, black-market shares could remain high.

In addition, it is important to assess the impact that grow cooperatives (co-ops) have on the market supply. These grow co-ops are conglomerates of growers that operate unlicensed businesses taking advantage of caregiver provisions found in Colorado law.53 Making projections of future demand and future challenges based on robust data are areas that require further research to provide policymakers with information to make necessary adjustments to existing regulatory frameworks and public policy as necessary.

49 Ibid at 11. See also Beau Kilmer, Jonathan P. Caulkins, Gregory Midgette, Linden Dahlkemper, Robert J. MacCoun, and Rosalie Liccardo Pacula, “Before the Grand Opening: Measuring Washington State’s Marijuana Market in the Last Year Before Legalized Commercial Sales,” Rand Drug Policy Research Center, 2013, http://www.rand.org/content/dam/rand/pubs/research_reports/RR400/RR466/RAND_RR466.pdf. 50 Ibid at 26. 51 Ibid at 27. 52 Ibid at 27. 53 While Colorado law does not specifically address the issue of patients joining together to create a collective or cooperative to grow and distribute marijuana to other patients, there are several rules and regulations governing the growth and distribution of medical marijuana by caregivers. See the Board of Health rules regarding the Medical Marijuana Program, Colorado Department of Public Health and Environment, Medical Use of Marijuana, 5 CCR 1006‐2. In addition, all caregivers must register their grow sites with the Colorado Department of Revenue. For more information refer to an overview of caregiver rules and regulations found at: http://www.colorado.gov/cs/Satellite/CDPHE‐CHEIS/CBON/1251593017198.

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APPENDIX A Denver Tax Glossary

Sales Tax - The Denver Revised Municipal Code (D.R.M.C.) imposes sales tax at the rate of 3.62 percent on the purchase price charged and paid on retail sales, leases, or rentals of tangible personal property and certain services. Any person or legal entity making taxable retail sales in Denver is required to obtain Denver sales tax license to collect and remit sales tax to the City.

Use Tax – D.R.M.C. imposes use tax at the rate of 3.62 percent on the purchase price of tangible personal property and certain services that are used, stored, distributed, or consumed within the City when there has been no previous payment of a legally imposed sales or use tax equal to or greater than the Denver rate. A reduction to the amount of the use tax due is allowed for the legally imposed tax previously paid to other taxing jurisdictions for the same purchase transaction. For example, if an item subject to use tax is purchased and picked up in the City of Lakewood, the deduction of any Lakewood sales tax charged and paid to the vendor is allowed from the use tax owed to Denver.

Taxpayers liable for use tax who are not subject to sales tax must obtain a Consumer Use tax license with the City. Use tax is reported on Schedule B of the combined sales/use tax return.

Occupational Privilege Tax (OPT) – D.R.M.C. imposes OPT on individuals who perform sufficient services within the City to receive compensation of at least five hundred dollars for a calendar month and businesses operating within the City. Lack of physical residency by an employee or a physical location by a business within Denver does not preclude them from OPT liability.

OPT has two distinct parts: the Employee OPT and the Business OPT. The Employee OPT at the monthly rate of $5.75 must be withheld from an employee’s pay by the employer. The employer is also required to pay the Business OPT at the monthly rate of $4.00 for each taxable employee. Additionally, the Business OPT tax of $4.00 per month is due for each owner, partner, or manager engaged in business in Denver regardless of the amount these individuals earned. Employees who perform services for a single employer, but whose work is performed in more than one jurisdiction that imposes OPT, such as the City of Aurora, are required to pay the tax only in the jurisdiction in which they spend the majority of their working hours. This exemption applies to the employer as well as to the employee. However, there is no exemption for an employee who performs services for the same employer in Denver and a municipality that does not impose OPT. In this case, the amount of work time spent in Denver versus the other municipality does not matter as long as the employee meets the five hundred dollar earnings requirement in Denver.

Businesses subject to the City OPT must obtain an OPT license and remit both the Employee OPT and Business OPT on a monthly basis if they have ten or more employees.

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Quarterly or annual OPT filing and remittance may be allowed for the businesses with less than ten or zero employees.

Source: City and County of Denver Tax Guides, Topic No. 70,”Sales Tax”, Topic No. 83, “Use Tax”, and Topic No. 61, “Occupational Privilege Tax, OPT or Head Tax”.

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APPENDIX B Other City Agencies with Marijuana-Related Duties

Source: City Executive Director of Marijuana Policy. The information in this table may not include all duties of a particular department or agency relative to marijuana. Additionally, the information may not include all agencies, particularly those with duties incidental to marijuana.

Department/ Agency

Department of Excise and Licenses

Department of Environmental Health

Department of Community Planning and Development

City Attorney's Office

Denver Fire Department

Denver Police Department

Department of Finance

Office of Children's Affairs

Department of Parks and RecreationDepartment of Technology Services

Department of General Services

Conducts inspections of marijuana facilities for initial business licenses, issues licenses, and conducts annual renewal of business licenses.

Summary of Marijuana-Related Responsibilities

Inspects marijuana facilities for compliance with food safety regulations and sustainability requirements.

Will collect marijuana-related data to create an operational dashboard of marijuana metrics.Manages the City facilities where payments related to marijuana are made.

Will act as a fiscal agent in a contract with the State to collaborate on a youth prevention education campaign.

Inspects marijuana facilities for compliance with the building code and neighborhood inspection regulations.

Inspects marijuana facilities for compliance with the fire code. The Fire Department also responds to emergency calls related to marijuana.

Develops strategies regarding marijuana, including public consumption and distribution of marijuana in parks.

The divisions of Prosecution and Code Enforcement, Lititgation, and Municipal Operations provide legal services related to marijuana to various City agencies.

Budget and Management Division and Treasury Division perform financial functions related to marijuana, including but not limited to budgetary duties and collection, and recording and depositing of taxes.

Enforces laws and responds to emergency calls related to marijuana.

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APPENDIX C Treasury Collection Process

Source: Audit Team

We prepared this simplified version of the collection process map provided by Treasury.

TRA is required to make collection phone calls within a time frame

driven by amount of TP tax liability. Additional phone calls and/or written notices are utilized as needed.

Did the TP committo pay and file required

return if applicable?

TRA’s are required to keep agreed payment dates to as

short a time‐frame as possible (generally 7 – 10 business days). Collection efforts cease until payment

due is received

TRA is required to conduct field visits within a time‐frame driven by amount of TP tax liability. Additional field visits and/or written notices are

utilized as needed

Payment received as agreed?

Process terminated –No further compliance

efforts required.

Yes

Did the TPPay at the time ofThe field call orCommit to pay?

Yes – Paid at the time of Field Call

Payment received as agreed?

Yes – Made Payment Commitment at time of Field

CallProcess terminated –No further compliance

efforts required.Yes


efforts required.

Tax Reporting Accounts are set up in Treasury tax System (GenTax)

Every month 20 days after a tax return due date, GenTax runs a report of

delinquent accounts

Delinquent Tax Collections

Tax Returns that are filed, are input to GenTax, along with the recording of matching payment.

Underpaid Tax Collections

Did the Taxpayer ( TP) File

the Required Return and Pay Their Tax?

GenTax generates delinquent notices that are mailed to TP and creates a collection case assigned to Tax Revenue Agent

(TRA) through automated workflow

TRAs receive their daily work consisting of assigned collection cases utilizing GenTax. Prioritization and sorting by GenTax is based on the amount of the liability associated with the collection case.


efforts required.

Yes

Was the tax return and payment filed timely,

and was free from errors?


efforts required.

Yes

Gentax calculates underpayment and

generates underpayment notice to be mailed to TP

and assigns an underpayment collection

ease to TRA

This is a formal notice that advises the TP that they have 30 days to either pay the assessment or file a formal protest of the assessment with the Manager of Finance and schedule a hearing. This notice also advises the TP that if they fail to pay or protest within the 30‐day period, then the next step is the issuance of a distraint warrant for the seizure and subsequent sale of the business assets to pay the tax

liabilities.

No

Did the TPpay within the required

30 day timeframe?

This is the final step in the collection process.Treasury Agents/Enforcement Officers execute distraint warrants. A seizure involves actually taking possession of a business location ‐ changing the locks and evicting the

business personnel. Rare cases reach this point.

NoProcess terminated –No further compliance

efforts required.Yes

No

Yes

No

No

No

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APPENDIX D Treasury Audit Process

Source: Audit Team

We prepared this simplified version of the audit process map provided by Treasury.

Consent Executed? NoIssue Estimated Assessment

Perform Field Audit

Track consents for Expiration/Statue of Limitation

Consent Expired Send New Consent

New Consent Executed?

No

Issue Assessment Based on Estimate or Audit Status

IssueWorkpapers,

Ready to Pay Bill?

Consent Issue/Protest?

Yes

Issue Assessment

Notice

Issue Notice of Proposed Deficiency

Paid in Full?

No

Yes

Protest or Additional Info.

By TP

Yes

No

Create an Installment Plan

Paid In Full?

EndYes

NoSend to Enforcement for

Collections

No

Initiate Audit Request

Approve and/or Assigned (by Supervisor)

Yes

Set up, Schedule Audit and Send Engagement Letter and

Consent for Statute of Limitation to Taxpayer (TP)**

Yes

Review Additional TP Documentation

and AdjustWorkpapers as

Needed

No

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AGENCY RESPONSE

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DENVER THl MIU HIGH CITY

Michael B. Hancock Mayor

September 3, 2014

DEPARTMENT OF FINANCE

CARY KENNEDY CHIEF FINANCIAL OFFICER

201 W. Colfax Avenue, Dept 1010 Denver, CO 80202 p: (720) 913-1514 f: (720) 913-5599 www.denvergov.org/finance

Mr. Kip R. Memmott, MA, CGAP, CRMA Director of Audit Services Office of the Auditor City and County of Denver 201 West Colfax Avenue, Dept. 705 Denver, Colorado 80202

Dear Mr. Memmott:

The Office of the Auditor has conducted a performance audit of Medical Marijuana Taxation.

This memorandum provides a written response for each reportable condition noted in the Auditor's Report final draft that was sent to us on August 26, 2014. This response complies with Section 20-276 (c) of the Denver Revised Municipal Code (D.R.M.C.).

AUDIT FINDING 1 The Treasury Division Has Not Sufficiently Addressed the Unique Challenges of Tax Collection from the Medical Marijuana Industry.

RECOMMENDATION 1.1 Strategic Planning- Treasury should take on a more active role in the City's strategic planning for marijuana policy. Specifically, Treasury should, in collaboration with the Office of the Chief Financial Officer, ensure that the review of City tax compliance is one of the steps toward achieving the strategic goal of efficient and effective enforcement of MMJ regulation.

Target date to complete Agree or Disagree with implementation activities Name and phone number of specific point of

Recommendation (Generally expected within 60 contact for implementation to 90 days)

Agree Ongoing Bruce Moore, Director of Tax Compliance 720-913-9421

Narrative for Recommendation 1.1 Treasury has and will continue to participate in these efforts and will seek to augment our participation and collaboration as appropriate.

RECOMMENDATION 1.2 Compliance Audits- Treasury should expedite the completion of its ongoing MMJ industry audits and determine whether additional action regarding Treasury's tax compliance efforts is warranted, such as expanding the number of MMJ audits conducted.


Recommendation (Generally expected within 60 to contact for implementation 90 days)

Agree 12/31/2014 (For most of the Bruce Moore, Director of Tax Compliance MMJ Audits Currently Underway) 720-913-9421

Page -1- of6

Narrative for Recommendation 1.2 Treasury will seek to expedite the current MMJ industry audits as much as reasonably possible (when auditing taxpayers, we must of course deal with constraints based on them complying with our requests in a timely manner, such as providing records, scheduling on-site visits, etc.). Additionally, we must temper efforts to expedite completion of audits against our professional compliance auditing standards.

Our professional standards require that we obtain sufficient audit evidence to identify material tax liabilities owed and material issues of non-compliance with tax law, regulations and procedures. These standards help us to achieve our overall auditing objectives of recovering tax monies owed, increasing voluntary compliance, and providing taxpayer education. Specifically, identifying taxes owed allows us to assess and collect those taxes (revenue recovery objective) and identifying material tax issues of non-compliance allows us to educate taxpayers, and to promote and increase future voluntary compliance.

Additionally, in responding to the recommendation that we determine whether additional tax compliance efforts are warranted, Treasury had also designed and begun in 2013 an overall industry statistical sampling project (using the 25 industry audits undertaken thus far) to identify industry trends and to help determine whether our additional marijuana industry specific auditing procedures are adequately working, and whether we would need to change/add to them or to indeed undertake additional efforts, such as expanding the number of audits, as this performance audit has mentioned.

Please note, we have already reported to the Denver Auditor's Office auditors, with about 25% of our statistical sampling project completed, some preliminary findings:

• About 75% of the assessments thus far, are for use tax and business personal property taxes, which are typical issues with any business.

• About 25% of the assessments thus far comprise sales tax. For the sales tax assessments, about 40% is for exempt sales (State exempt, not City) and about 55% is for resale documentation issues (large sales where a large amount of product was sold to a buyer, but the taxpayer did not have/retain documentation showing that the sale was a proper wholesale sale).

We also advised the Auditor's Office, that at this point, with 25% of the industry statistical study in; we don't have enough data to draw any final conclusions with a reasonable amount of confidence or precision. Overall though, we reported that the results of the audits thus far, show that the medium to larger size marijuana business taxpayers have average use tax and business personal property tax liabilities (actually typical of all industries) while sales tax (the primary taxes associated with this industry) comprise a smaller percentage of the non-compliance issues. Treasury is targeting 12/31/2014 as a completion date for the industry statistical sampling project.

RECOMMENDATION 1.3 Educational Outreach- Treasury should develop taxpayer information and educational material specific to the MMJ industry and disperse it as needed.



Agree 10/31/2014 Bruce Moore, Director of Tax Compliance 720-913-9421

Narrative for Recommendation 1.3 Treasury agrees with this recommendation and will produce a tax guide topic specific to the marijuana industry, and include it in our tax guide and all our other taxpayer education information channels (website, taxpayer service) and will additionally mail it to all marijuana related businesses in Denver.

Page- 2- of6

RECOMMENDATION 1.4 Inter-Agency Coordination- Treasury should initiate outreach to the State of Colorado and other tax jurisdictions to share information and ideas about the risks and trends associated with the MMJ industry. As part of this outreach, Treasury should explore the possibility of using the state-mandated marijuana inventory tracking system or other system for sales tax audit purposes.



Agree Ongoing Bruce Moore, Director of Tax Compliance 720-913-9421

Narrative for Recommendation 1.4 Treasury has and will continue to collaborate with other jurisdictions regarding the marijuana industry and will seek to augment those efforts as appropriate. Note: Treasury had already requested access to the state-mandated marijuana inventory tracking system from the State of Colorado Marijuana Enforcement Division, but to be clear- we have no control over whether we will be granted access.

ADDITIONAL NARRATIVE IN RESPONSE TO OVERALL AUDIT FINDING

Treasury appreciates the efforts of the Auditor's Office and the recommendations made, and as detailed above we have agreed with all of the recommendations. However, for the record, we disagree with the overall finding stated above: "The Treasury Division Has Not Sufficiently Addressed the Unique Challenges ofTax Collection from the Medical Marijuana Industry."

We disagree for the following reasons:

1. The performance audit did not identify any evidence that taxes for the medical marijuana industry were not being properly collected.

To be clear, Treasury has not, and is not cla iming that we are collecting every last penny (100%) of all taxes for the medical marijuana industry, we make no such claim for any industry, as it is simply not possible, and no taxing authority at any level of government would make such a claim.

However, it is not our burden to prove that we are collecting 100% of all taxes (i.e. prove the negative) but it is our opinion that for this performance audit to claim that we have not sufficiently addressed the unique challenges of tax collection from the medical marijuana industry, then such an assertion should be based on demonstrable audit evidence. At no time, throughout this performance audit, and through the extensive interaction that tax compliance personnel had with the Auditor's Office auditors, did the auditors ever indicate, identify or discuss that they had found any evidence that tax monies from medical marijuana businesses were not being collected, nor does the performance audit report identify any such evidence.

2. The performance audit report does not report out on Treasury's standard tax compliance activities and procedures (and minimizes the additional efforts/activities Treasury specifically designed to mitigate the tax compliance risk associated with the unique characteristics of the marijuana industry) that do demonstrate the effectiveness of our efforts.

For context - all tax compliance programs at any level (federal, state, or local) share core standard practices, which are:

A) You have to identify who your taxpayers are (if you don't know they exist, they are probably already out of compliance).

B) You have to ensure that all taxpayers are set -up with reporting accounts and that they file all applicable tax returns and pay the taxes associated with those returns.

Page- 3- of6

C) You have to engage in tax compliance auditing, which ensures that taxpayers are paying the correct amount of tax when they are filing returns. If not, then auditing recovers any unreported/unpaid taxes, and identifies other tax issues so that a taxpayer can be educated, and thus voluntarily and correctly comply in the future.

These standard practices are just as applicable to the marijuana industry as any industry, and Treasury provided the Auditor's Office with reasonable audit evidence to demonstrate their effectiveness. The performance audit report does not cover any of our standard tax compliance practices, yet in a prior performance audit of our tax compliance activities on occupational privilege tax (our standard practices apply to all tax types) in 2010 the City Auditor's Office described our audit and collection practices as;

o "Audit work indicated the Treasury Division has an adequate Occupational Privilege Tax (OPT) audit and collection process, evidenced by the utilization of new tax audit software, the presence of assertive tax collection processes, a robust training program, measurable staff performance standards and active involvement in community outreach. The presence of these attributes indicates Treasury remains focused on providing value to the citizens of the City and County of Denver."

o "Audit work determined that the Treasury Division's Occupational Privilege Tax (OPT) audit and collection practices, level of compliance with legal requirements and community outreach activities are sound. In addition, internal tax audit and collection functions appear to be thorough, well developed and measureable. A review of the tax audit process indicated a thorough methodology is applied for assessing tax compliance with the D.R.M.C. The Colorado Local Tax Collectors Association has conducted multiple surveys over the last several years comparing the tax collection process of various municipalities. This survey revealed the City and County of Denver has an assertive tax collection process when compared to other government entities."

That report, while recognizing that our overall tax compliances activities were sound, did identify that we could enhance our tax collection processes and possibly bring additional revenues into the City, which was fair and standard for a performance audit (i.e. identified what you are doing well, and where you could improve). We mention this previous report only to point out that we are employing the same standard practices that were recognized as being sound and effective by the Auditor's office just a few years ago, yet now are being overlooked. These practices are the basis for all of our tax compliance activities; they are not rendered null and void just because the product being sold is marijuana.

In reference to the additional efforts designed by Treasury specifically for the marijuana industry, the performance audit report discusses those on page 9:

"Audit inquiries showed that Treasury has supplemented its standard tax compl iance practices with several additional efforts intended to mitigate some of the potential risk associated with taxing MMJ businesses. Specifically, Treasury has reported (emphasis added) that they have:

• Placed MMJ businesses into a category of high-risk businesses that includes bars, liquor stores and restaurants. As these are cash-intensive operations and volatile businesses, Treasury requires all businesses designated as high risk to file sales tax returns and remit sales tax due monthly, instead of quarterly or annually, regardless of the associated amount of tax liability.

• Reconciled MMJ tax account data with the licensure data from the Department of Excise and Licenses and the State of Colorado to ensure that MMJ businesses are licensed and being taxed accurately based on their business type

• Developed eleven reports in the Treasury tax system specific to the marij uana industry to review the industry tax data including, but not limited to, delinquency data

Page- 4- of6

• Developed additional tax audit procedures for cash-intensive MMJ businesses to mitigate the risk of underreported sales

Although these additional steps are appropriate and could serve (emphasis added) to increase compliance by those in the MMJ industry, Treasury does not have sufficient data to show whether the controls adequately mitigate the risk of tax revenue loss due to the unique challenges that MMJ businesses pose."

Noting the emphasized terms above "reported" and "cou ld serve" they can easily give the reader of the report the impression that these were efforts that were merely reported to the Auditor' Office, but not examined and audited. This is not the case, the City Auditor's Office auditors (as they should have) did thoroughly examine these efforts, and we believe that (in particular) in the case of the efforts described in the first three bullet points they were provided strong evidence that these efforts are now and have been working well since the industry began a few years ago. The thoroughly audited efforts described in the first three bullet points, combined with our standard practices (addressed above) ensure that we are effectively achieving the first two core standard practices detailed above (i.e. you have to identify your taxpayers, and you have to ensure they are filing and paying their tax returns) for the medical marijuana industry.

Where the City Auditor's Office auditors focused their attention, and took exception was their belief that Treasury should have commenced our tax compliance audits of the medical marijuana industry sooner, rather than waiting for three years. It seems that it is this belief, regarding the timing of our audits, which forms the basis for their statement; "Treasury does not have sufficient data to show whether the controls adequately mitigate the risk of tax revenue loss due to the unique challenges that MMJ businesses pose." This is a true statement (as it pertains to our auditing activities only) and as we readily documented and stated above in the narrative for recommendation 1.2. However, this is not an accurate statement for our standard practices and activities that apply to all industries including the marijuana industry, nor is it accurate for the other additional compliance activities (non-auditing) developed for the medical marijuana industry (as discussed above), as again these were audited and in the field exit meeting the auditors acknowledged that we were "doing a good job."

In regards to our tax compliance audits (their timing) of the medical marijuana industry, The Auditor's Office simply has a different opinion, as they believe we should have commenced the audits sooner, and by inference we would thus now have "sufficient" data to determine if our compliance tools (again we assert this would be applicable only to our auditing activities) are effective. Treasury management deliberately chose to wait for three years for sound taxation law, and tax compliance practice reasons, which the performance audit report mostly details on page 10, but to be clear it was also to ensure that we had sufficient data to do an overall industry study to determine trends and issues as a whole, we needed enough time to elapse (three full annual cycles) business activity to occur, and records to examine to arrive at valid conclusions. If our statistical sampling project (again described in narrative for recommendation 1.2) did not have enough data and audit evidence to examine it could lead to erroneous conclusions and send us down wrong and unproductive paths. So we believe it is arguable on whether commencing the audits sooner would have resulted in both "sufficient" and accurate data. In any case, we should soon have the data and we will evaluate the results and proceed accordingly (again as detailed in the narrative for recommendation 1.2 we are already seeing some preliminary trends).

3. The performance audit report suggests that the inherent unique characteristics of the marijuana industry (characteristics completely out of Treasury's or any Colorado taxing jurisdiction's control) are also responsible for the stated overall finding. However, the Auditor's Office did not identify or suggest any different or additional steps specific to these unique characteristics that we should be doing to mitigate or address these characteristics.

The unique characteristics of the marijuana industry that create tax compliance challenges are:

• A sizable number of transactions are made in cash. • Because marijuana is still illegal under federal law, the marijuana industry generally does not have

access to regular banking services (banking records provide important documentation that tax auditor's look for to help verify sales activity).

Page- 5- of6

• Most medical marijuana businesses grow their own inventory, which eliminates a standard audit trail (wholesale sales from supplier to retailer) and thus makes it difficult for tax compliance auditors to track and reconcile sales to purchases of inventory.

The performance audit report correctly describes these challenges, and even has a very informative section regarding this issue in the "Other Pertinent Information" section. To clarify though, Treasury (as well as all the other Colorado taxing jurisdictions that have marijuana businesses) has been fully aware of and grappling with these challenges since the marijuana industry started several years ago. None of this information was new to us (this information has also been extensively reported in the press) and we had already developed the additional tax compliance steps and efforts to mitigate these unique characteristics as discussed extensively in this response. Therefore, to have a finding that "the Treasury Division Has Not Sufficiently Addressed the Unique Challenges of Tax Collection from the Medical Marijuana Industry" when the Auditor's Office did not identify anything that we should be doing in addition to what we had already implemented to mitigate the unique characteristics seems to constitute an unsupported finding.

4. Based on all of the foregoing, we believe that the recommendations made don't actually line up with or support the stated overall finding.

In conclusion, my staff and I thank the Auditor's Office for their recommendations; they will undoubtedly be helpful as we continue to work with this industry.

Please contact Steve Ellington 720-913-9384 or Bruce Moore 720-913-9421 with questions.

cc: Scott Martinez, City Attorney David Edinger, Chief Performance Officer John Carlson, Deputy Director of Audit Services Chris Wedor, Audit Services Supervisor Steve Ellington, Treasurer Bruce Moore, Director of Tax Compliance

Cary Kennedy Chief Financial Officer

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Medical Marijuana Taxation Performance Audit

Documents