With a Tax Deal in Place, Canada Is 1 Step Closer to Legalizing Recreational Marijuana

A cannabis joint being held in front of Canada's red maple leaf.

Investors would be hard-pressed to find an industry that's delivered better returns in 2017 than legal marijuana. Of the marijuana stocks with a market cap of $200 million or higher, a majority have at least doubled in value during the course of the year -- and it's not hard to understand why.

ArcView, a leading cannabis research firm, is projecting that the North American legal-weed industry could grow at 26% a year through 2021. Based on the $6.9 billion in legal cannabis sales logged in North America in 2016, this suggests a market worth nearly $22 billion by 2021. Investment firm Cowen & Co. takes things even further by forecasting $50 billion in legal sales just in the U.S. by 2026. Should these robust growth estimates come to fruition, pot stock investors could be sitting on a green gold mine.

There has also been a discernable shift in the way the American public views marijuana. Gone is the idea that weed is a taboo topic that should be swept under the rug and never spoken of. Instead, according to both Gallup's and CBS News' 2017 polls, a record number of respondents favor the idea of legalizing pot (64% and 61%, respectively).

Is Canada about to "go green"?

Yet, it's not the United States that's leading this green rush among marijuana stocks. The U.S. federal government has dug in its heels on its Schedule I categorization of marijuana, ensuring it remains an illegal substance with no recognized medical benefits. This scheduling adds layers of red tape to any clinical research and makes life incredibly difficult to marijuana-based businesses. For instance, they often have minimal or no access to basic banking services, and are forced to pay an effective tax rate of 70% to 90% (compared with 15% to 30% for a "normal" business) because they're unable to tax normal corporate income-tax deductions.

Instead, it's been our neighbors to the north, Canada, that have shown investors the true potential of marijuana stocks. Having legalized medical cannabis in 2001, growth in Canada's medical marijuana market has exploded in recent years. According to Health Canada (Canada's equivalent to the U.S. Department of Health and Human Services) in May, the number of eligible medical patients was increasing by about 10% a month .

More ambitiously, though, Prime Minister Justin Trudeau introduced legislation in April designed to legalize recreational marijuana by July 2018. Uruguay is the only other country worldwide that's legalized adult-use weed, meaning Canada would be joining some pretty rare company.

Canada's push to legalize adult-use weed has encountered numerous obstacles

As you might imagine, there are a number of hoops to jump through in order to get such an ambitious plan in place. More specifically, there are objections that need to be dealt with from the more conservative members of Canada's parliament. For example, there are concerns that a home-grow option will give adolescents easier access to cannabis. And since regular cannabis use has been shown, in some studies, to adversely affect long-term memory and cognitive function, it's a genuine concern.

In addition, conservatives in Canada's parliament worry about consumers who will drive under the influence of tetrahydrocannabinol, or THC, the psychoactive component of cannabis. While there are pretty cut-and-dried levels of blood alcohol content to determine how impaired a driver is, there aren't any lines in the sand when dealing with THC in a person's system. Thus, enforcement of driving while under the influence is sketchy at best.

A third issue comes from Canada's provinces. Since they are the frontline for regulating cannabis and enforcing the law, officials in these provinces worry that they won't have the manpower or funding to properly enforce the law if it's rolled out in July 2018.

A fourth and final issue is that of ensuring regulated cannabis and black market cannabis are priced similarly. To drive consumers to purchase in legal channels, the taxes attached to legal cannabis have to be low enough to remain competitive with black market weed.

Canada just resolved a major marijuana problem

In October, the Canadian government appeared to address this last issue above by outlining its tax policy on cannabis . According to officials, the proposal involved a $0.78-per-gram tax on marijuana sales costing up to $7.80 a gram, and then a flat 10% on more expensive marijuana. This would place the tax on pot at less than that of alcohol in Canada and give legal weed channels a real shot at being competitive on price with black market cannabis.

However, Canada's provinces were none-too-thrilled with this tax proposal, namely because it split tax revenue 50-50 between the government and provinces. Provincial mayors and officials have argued incessantly that more of a share of revenue was needed to ensure enforcement given that they bear more costs than Canada's federal government in enforcing the rules. This past week, a resolution was finally reached.

As reported by BBC, the provinces agreed to a two-year tax sharing agreement that'll send 75% of the tax revenue collected back to the provinces, with the Canadian federal government retaining the other 25%, up to $78 million per year. If demand is somehow above expectations and the federal government hits its $78 million annual limit, any additional taxes collected will be returned to the provinces. This should, in theory, give provinces the funding they need to set up the distribution framework for recreational weed, as well as regulate and enforce any laws associated with its legalization.

What's more, with progressive lawmakers maintaining a majority in parliament, it's looking as if Canada's conservatives have few, if any, pathways to stop the legalization effort.

This is great news for Canada's green quartet

With tax issues now out of the way, it's looking ever more likely that Canada's four major growers -- Canopy Growth Corp. (NASDAQOTH: TWMJF) , Aphria (NASDAQOTH: APHQF) , Aurora Cannabis (NASDAQOTH: ACBFF) , and MedReleaf (NASDAQOTH: MEDFF) -- will see a major uptick in sales and demand in the months to come. Not surprisingly, they've all been pouring money into capacity-expansion initiatives.

Canopy Growth, the largest Canadian pot stock by dried cannabis market share, has mainly been acquiring capacity. It purchased Mettrum Health to begin 2017, and noted in its second-quarter operating results release that it had 2.4 million square feet of capacity under development or construction in British Columbia, with the option of acquiring another 1.7 million square feet in B.C. It could be extremely difficult for any grower to match Canopy Growth's annual output.

Aurora Cannabis has taken something of a dual approach. It's currently constructing the Aurora Sky project, an 800,000-square-foot highly automated facility that'll be capable of 100,000 kilograms of dried cannabis production annually once complete in mid-2018. But it's also made an unsolicited bid of up to $425 million for CanniMed Therapeutics . The combined entity could be capable of 130,000 kilograms of dried cannabis production a year.

Comparatively, Aphria and MedReleaf are approaching things organically. Aphria's more than $100 million four-phase project will yield around 100,000 kilograms of dried cannabis annually as of completion in Jan. 2019. Meanwhile, MedReleaf is using the proceeds from its recent initial public offering to expand its Bradford facility in Ontario.

Though recreational legalization has arguably been priced into Canadian pot stocks, they may have more room to run once sales begin streaming in, assuming approval.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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