The cannabis industry in Puerto Rico is tightly regulated by the Junta Reglamentadora del Cannabis Medicinal (“Junta”), which was established under Act 42 of 2017 (the “Act”) and Regulation 9038. These laws govern the licensing, ownership, and compliance requirements for businesses involved in the cultivation, manufacturing, laboratory services, transportation, and dispensing of medicinal cannabis. Below, we provide a detailed breakdown of how these regulations affect foreign investors interested in entering the industry, drawing on the Act, Regulation, and the various resolutions, circular letters, administrative orders, and guidance issued by the Junta.
Residency Requirement
One of the key provisions in the Act and Regulation is the residency requirement, which mandates that at least 51% of the ownership of any cannabis-related business must originate from Puerto Rican capital. The Act states that “51% de la titularidad provenga de capital de Puerto Rico,” which translates to 51% of the ownership or title originating from Puerto Rico capital. However, the specific language creates some confusion, as it could be interpreted to refer to either ownership or capital.
In the absence of additional guidance from the Junta, the best interpretation seems to be that 51% of the owners of the business must be Puerto Rico residents, rather than 51% of the capital coming from Puerto Rico. This interpretation aligns with the “letter of the law” approach, as there is no other explicit guidance clarifying this provision.
Licensing Compliance
To obtain and maintain a license in Puerto Rico’s cannabis industry, businesses and their owners face significant regulatory requirements. These include submitting a wide range of documents and meeting specific criteria, such as:
- Photo ID
- Criminal background certification from the Puerto Rico Police Department
- Fingerprinting and background check
- No felony convictions
- Statement of financial capacity
- Negative debt certificates from both the Departamento de Hacienda and CRIM (Centro de Recaudación de Ingresos Municipales)
For corporate entities, these requirements extend to all owners, shareholders, members, directors, and officers of the company (at least those over a 5% interest). Additionally, corporate applicants must provide:
- Corporate bylaws
- Corporate structure report
- Statement of financial capacity
- Good standing certificate from the PR State Department
- Board of directors information
- Security contracts
If a cannabis business changes ownership, it must submit a new application that includes the above information, as well as:
- Reason for the change of ownership
- Names and addresses of all new owners
- Names and addresses of any person with participation as a partner
- Information regarding management, economic relations, and interests related to the license
- Payment of required fees
Enforcement Actions and Penalties
The Junta has broad authority to conduct investigations, inspections, and enforce the provisions of the Act and Regulation. Businesses may be subject to enforcement actions for various reasons, including:
- Failure to submit required information
- Submission of fraudulent information
- Violations of public policy as determined by the Junta
Penalties for non-compliance can be severe and include:
- Inspections of establishments
- Review of books and records
- Suspension or revocation of licenses
- Impounding of products
- Monetary fines, ranging from $5,000 to $20,000 for non-grave offenses and $20,000 to $100,000 for grave offenses
Structuring Investments: The Management Company Approach
Given the extensive requirements and potential penalties, it can be daunting for new investors to enter the Puerto Rican cannabis industry. To overcome these hurdles, investors may look into using a management company model. Under this model, the local cannabis business retains its current ownership structure, and a separate management company is formed to provide capital and consulting services to the local entity. This management company would not own equity in the local entity but would earn a percentage of revenues or profits in exchange for its services.
This approach offers several advantages, including avoiding the regulatory burden of changing ownership and sidestepping the need to submit extensive documentation for new owners to the Junta. The management company, incorporated in Puerto Rico, would not hold any equity, voting rights, or board seats in the local entity.
Key Elements of the Management Agreement
- The management agreement between the local entity and the management company would likely include provisions such as:
- Scope of services: Administrative, operational, financial, and compliance services; marketing, human resources, and supply chain management; leasing equipment and facility management.
- Compensation: Fixed or variable management fees, performance-based fees tied to
- revenue or profits, and potentially profit-sharing arrangements.
- Term and renewal: Initial terms of 3-5 years with automatic renewal unless terminated with notice.
- Non-ownership clauses: Explicitly stating that the management company holds no equity or control in the local entity.
- Decision-making authority: Ensuring key decisions remain with the local entity’s owners to comply with local residency requirements.
- Operational autonomy: Maintaining separation between the management company’s services and the local cannabis operations.
Tax Implications and Incentives
Non-resident investors who invest through a management company may still be subject to U.S. federal tax obligations on income derived from their management company’s operations.
Key tax considerations include:
- Effectively connected income (ECI): U.S. trade or business income may be taxed at U.S. rates.
- Withholding requirements: Non-resident investors could face withholding taxes of up to 30%, although tax treaties may reduce this rate.
- Puerto Rican corporate tax: Puerto Rican entities are taxed between 18.5% and 37.5%, depending on taxable income, with an alternative minimum tax (AMT) ranging from 20% to 30%.
- Act 60 (formerly Act 20): Puerto Rico offers tax incentives for businesses that export services. If the management company qualifies under Act 60, it could enjoy a 4% corporate tax rate on income earned from providing services outside of Puerto Rico, including to the local cannabis entity.
Other Investment Options
While the management company approach may prove effective, there are other ways to
structure investments, such as:
- Convertible Debt: Non-resident investors could extend convertible loans to the local
entity, which may convert into equity if regulations change. - Promissory Notes: Investors can be given promissory notes to earn a return on
investment through interest payments, rather than equity. - Minority Ownership: Investors could hold a minority (less than 49%) stake in the local
entity, maintaining compliance with the 51% residency requirement. - Non-Voting Shares: Non-residents could be issued non-voting shares, with Puerto Rican
residents holding voting control. - Preferred Equity: Non-residents can hold preferred equity with preferential returns but
limited voting rights.
Ownership of Equipment and Improvements
The management company can own equipment and improvements used by the local entity, but these should be structured as part of the management services agreement.
Ownership can be retained by the management company, which would then lease the equipment to the local entity in exchange for fees or a share of profits. This ensures that the management company does not directly engage in cannabis cultivation, manufacturing, or retail—activities that require compliance with Puerto Rico’s residency and licensing laws.
Puerto Rico’s cannabis regulations are complex and impose strict requirements on ownership, licensing, and compliance. For investors and businesses looking to navigate these regulations, structuring investments through a management company can be a viable solution that avoids many of the pitfalls of direct ownership while allowing participation in the industry’s growth. However, businesses must pay close attention to tax implications, regulatory compliance, and the structure of management agreements to ensure they remain compliant with local laws and regulations.
