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Cannabis IP – What’s the Buzz all About Cannabis Intellectual Property?

Cannabis IP Intellectual Property

By Delia Rojas, Esq. and Ian Munc, CPA

Overview

The Cannabis IP – intellectual property being used in your cannabis company may be one of your most valuable assets.  While protecting those rights can be tricky, there are some methods available for doing so, and successfully protecting those rights may produce significant benefits both in terms of future valuation of your business as well as current tax minimization.  Read on to learn more.

The first step is to define and secure the rights to your intellectual property (“IP”).  The key is to know when your business has protectable IP, developing the rights within the IP and engaging in all avenues to protect such IP. The pathway to protection and utilization of your business IP depends on the type of IP.

Trademarks

A trademark can be a word, logo, symbol, or anything that can indicate the source of the goods or services. When choosing your mark, you want the mark to be both distinctive and exclusive. As a general rule, terms that are merely descriptive of products and services are difficult and most of the time incapable of being protected as marks. The distinctiveness of a mark is measured by the overall strength of the mark in relation to the goods or services. There are 5 categories of strength that a mark can fall under. It ranges from weak non-registrable generic marks to strong fanciful marks.

For example, let’s say you are a cultivation business in Mendocino. You want people to know that your product is from this area and that its sun grown so you think of Mendocino sun grown or Mendocino Cannabis. These are extremely weak descriptive and generic marks. They refer to the exact product and place it’s from. If you thought of something like Northern Greens, that’s more suggestive which is protectable but can take a little more effort to prove. The strongest marks are either arbitrary or fanciful. Arbitrary marks are dictionary words that have nothing to do with the goods so for example maybe Avocado for cannabis flowers which are like Apple for computers. Fanciful marks are made up words specifically for your brand. I highly advise that you connect with an attorney to ensure you’ve chosen a protectable mark. There is nothing worse than exhausting funds into brand development only to find out you need to re-brand.

Once you have a mark that is distinctive, it must be exclusive. You should research your potential mark to identify any identical or confusingly similar marks already in the market for the same goods or services. You need to make sure that your mark is as exclusive as possible. This not only avoids infringement but ultimately is a benefit to your business so consumers can recognize your brand and distinguish your goods from others.

Contrary to popular belief, rights in trademarks are not obtained through registration. Rights in a trademark are acquired through actual use in commerce in connection with the specific goods or services. You cannot apply for registration from the state or federal government without actual use of the mark in commerce. Even if the jurisdiction offers an application for an intent to use the mark, full registration is not issued without demonstration of actual use.

Since cannabis is still a Schedule 1 drug, you cannot obtain a federal registration for your cannabis products. What you can do is file for ancillary products and services such as apparel, stickers, lighters, education, etc. So, what about the actual cannabis products? State registration. You should register your mark with the California Secretary of State Office to support your rights in the future. When cannabis becomes legal (hopefully within the next year or so?!) you can file for a federal registration and if there are any conflicts you have the state registration to support your use and ownership. Before you file any application, please at least consult an attorney. The application seems simple but there are layers of nuances and regulations that need to be followed.

Copyright

Copyright law protects the original creative expression put into a tangible medium. Copyright protected materials can range from documents to lists, to paintings and music. It’s important to understand that copyright protects the expression of ideas and not the ideas themselves. You can copyright the story within the book but you cannot copyright the genre of books. Copyright law provides an owner of a work with 6 rights, a “bundle of rights,” including the right to reproduce, prepare derivative works, distribute, perform, display, and perform sound recordings through digital audio transmission.

Copyright rights are provided and protectable upon the creation of the work. Registration is not required in order to gain general common law rights but just as in trademark law, registration provides ample benefits to the owner. A few of these benefits are the authority to bring a lawsuit, eligibility for statutory damages and recovery of attorney’s fees, and eligibility to request blocking the importation of counterfeit items.

As a cannabis company, a few works that you may want to protect are artwork, publications, videos, or potentially your website. To register your work, there is a simple application on the Copyright Office website. You fill it out, pay the fee and generally mail in the “best copy” of your work.

Trade Secrets

Trade secrets can be a very important asset in the growing cannabis industry and yet one of the most overlooked and difficult to protect. This is because trade secrets are valuable due to their secrecy.  A trade secret is any information, including but not limited to a formula, pattern, method, customer list, affiliate list, recipe, or process that: (1) derives independent economic value, actual or potential, from not being generally known to the public or other persons who can obtain economic value from its disclosure and use; and (2) is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.

For the trade secret to remain a protectable asset, the steps taken to maintain secrecy and avoid disclosure of such information are imperative. California has defined reasonable efforts to include advising your employees that there are trade secrets, limiting the access to such information to people that are on a ‘need to know” basis, and requiring all employees or individuals that will be encountering such information sign a non-disclosure agreement prior to disclosure. Trade secrets are not registered or otherwise filed with a governmental agency. The rights are obtained through the actions of the entity (or owner) of the trade secret.

Patents

Patents are another type of IP. The specifics of patents are beyond the scope of this article, but generally speaking, patents can protect both specific strains/plants and methods, processes, tools or devices. To be patentable the subject matter needs to be new, non-obvious, and have some utility. There are three different types of patents; two specific plant patents and one utility patent.  Patents are extremely complex and require guidance from attorneys who specialize in patent law.

Ownership

Before you register your IP, it’s a good idea to consider who will own and ultimately exploit the IP. One strategy is to create a new entity that holds and utilizes your IP separate from your cannabis business. Once your entity is created, you can list the entity as the owner on all IP registrations. For works that aren’t registered, just make sure to consistently name the entity as the owner in any documentation. It’s important that any person (employee or otherwise) that works on the IP assigns all their rights, if any, within the IP to the entity in writing. The entity needs to continue to maintain control of the IP in order to maintain its ownership. This strategy can be beneficial especially in the cannabis industry as the new entity wouldn’t be subject to 280E (explained further below).

Tax Implications

Ok, now that the intellectual property is created and held in a separate entity, let’s talk about how the relationship might work between the IP holder and the licensed cannabis business.

But first, a word of caution before we get to the nitty-gritty.  1)  This is a relatively new area for cannabis companies and the IRS has not yet weighed in on whether they will respect the characterization of these arrangements.  Businesses looking to utilize these strategies should be aware of the uncertainty of using cutting-edge tax planning techniques and be aware of the possibility that the IRS might try to recharacterize the whole arrangement as one “unified enterprise,” thereby subjecting both companies to the draconian effect of 280E.  2)  There is a fine line but an extremely important distinction between tax planning and tax fraud.  Business arrangements that “lack economic substance” are likely to lead to unpleasant consequences for both the companies as well as their advisors.  Further discussion of the distinction between these two is beyond the scope of this article; however, we strongly advise those seeking to explore this area further to do so carefully, conscientiously and with lots of guidance from professionals in this area.  The purpose of this article is to get you thinking about the possibilities within these arrangements, not to provide specific advice on how to set it up or operate it.  ALWAYS consult your legal and tax advisors when contemplating significant changes to your business operations.

Our first example will be a dispensary and an IP company that holds the rights to use the Tradename “Getting Irie Greatly Grows Loving Energy (GIGGLE).” The dispensary licenses the rights to operate branded GIGGLE Zones™ from the IP company, GIGGLE Holdco Inc.  This is very similar to a franchisor and franchisee relationship.  (Check with your State licensing advisor on the “financial interest holder” disclosure requirements, which may or may not apply to your specific situation).

The dispensary pays a royalty fee to GIGGLE Holdco Inc (there is some tension here between paying a fixed rate, which the BCC may prefer, and paying some kind of variable rate, which your accountant might prefer).  Dispensary deducts those payments (consult your tax advisor).  GIGGLE Inc receives royalty income from the dispensary and spends money on “brand development and marketing.”  This is the key part for the tax benefit portion of these arrangements.  Were GIGGLE Inc to be the same entity as the dispensary operator, it would have a very difficult time deducting its marketing and brand development expenses.  However, an IP-holding company is not subject to 280E, and therefore would be able to deduct such expenses.  In fact, an IP holder that does not invest in maintaining or increasing the value of its IP is not respecting its fiduciary duty to its owners and could be sued for breach of fiduciary duty!

Let’s dive into the details of those activities a bit more.  It is this author’s opinion that GIGGLE Inc should be very careful to avoid any activity that would be considered a “selling” activity.  Marketing and brand development, a ok.  Selling, problematic.  Further, GIGGLE Inc should also be careful to avoid activities that “promote cannabis use” in general.  As much as possible, GIGGLE Inc should consider itself a “lifestyle brand” that happens to overlap with cannabis use.

Selling vs Marketing – “selling expenses” refers to the activity of exchanging two things of value, in this case, cannabis for money.  “Marketing expenses” however are expenses related to “creating awareness of and desire for your product or service” (though we would be careful about the “desire for” part). We believe that selling activities includes not just the activities of the transaction, but also activities that facilitate a sales transaction. Therefore, Giggle Inc should not advertise specific products, price points, or even store hours or locations.  It should not provide labor to the dispensary, should not accept payments on behalf of the dispensary, should not advise the dispensary on how to operate its business, should not even build or host the website of the dispensary.  Instead, GIGGLE should focus on educating the general public about all the fun being had at GIGGLE Zones™.  It can spend money on developing logos and branding, market research, developing and deploying marketing pieces promoting the power of embracing Loving Energy (LE) through GIGGL-ing, happy people giggling for no reason, their eyes bloodshot, their mouths dry, a bag of chips in their hands, etc.  (Ok, we might have gone a bit too far with that last idea).

Let’s talk more about the possible dangers of marketing activities that “promote cannabis use,” even in general – Most operators are probably well aware of the restrictions already in place when it comes to trying to advertise cannabis products or businesses.  Add to that the considerable effort and expense being expended to treat the IP holder as an IP holding company, and not a “Marijuana Trafficker,” and we believe you’re just inviting negative consequences by directly engaging in activities that promote cannabis use.  In a very public way.  Be smart about the risks you take.  Unless you love paying attorneys and accountants to defend you (and likely ultimately the IRS too).

Next, let’s discuss what it might look like for a manufacturer.  In this case, let’s say the IP holder holds a patent (or trade secret or know-how if a true patent is not possible) on a particularly effective means of extracting cannabinoids from cannabis plant material.  Once again, the license-holding manufacturer licenses the rights to use this IP from the IP holding company.  The manufacturer deducts the payment (consult your tax advisor).  The IP company then uses those proceeds to invest in further R&D, new R&D, etc.

Again, I would be very careful about the IP holder engaging in any selling (or facilitation of selling) activities for the manufacturer.  However, there are still many activities that the IP company can engage in that will benefit both the IP company as well as the cannabis business, without the worry of a 280E surcharge.

The situation for a cultivator is similar enough to that of the manufacturer that we won’t spend more time discussing it here, though we definitely see lots of possibilities for Trade Secrets and Know How to be utilized by a cultivator.

There could be a further opportunity to consider here.  Assuming we have set it up effectively so that the IP holding company can successfully withstand any attempts to recharacterize it as an extension of the cannabis trafficking business, what other general or administrative functions could be performed by the IP company that might otherwise be done by (or paid for by) the cannabis business?  Once again, there exists a delicate balance between making the most of an opportunity and pushing the boundary so hard the whole thing collapses.  Between organizing your affairs in such a way as to minimize your taxes (tax planning), and structuring transactions so that the true nature of the economic activity is obscured (tax and bank fraud).  As every Olympian knows, there’s a careful balance between pushing yourself to great heights and pushing yourself so hard you’ve ended your career.

Delia Ramirez is an attorney at Beck Law | Canna Legal located in Santa Rosa. Her practice focuses on corporate transactions, intellectual property, business development, and permitting and licensing for cannabis businesses. Delia strives to assist individuals and businesses in reaching their professional goals and she enjoys actively contributing to the vibrant cannabis community.

Ian Munc is a Principal at Munc CPA Inc. and a board member of Sonoma County Growers Alliance.  He is passionate about using his skills and knowledge to assist entrepreneurs dedicated to creating the legal framework for Ganja culture, spreading Peace and Love through the power of Clean Cannabis.