Illicit Tobacco
Various Schemes Are Used to Evade Taxes and Fees
Gao ID: GAO-11-313 March 7, 2011
Federal and state governments have raised excise taxes on tobacco products to discourage tobacco use and increase revenues. Cross-border and illicit trade in tobacco products can undermine these policy objectives by avoiding excise taxes and increasing the availability of these products to consumers at lower cost. On June 22, 2009, Congress passed the Family Smoking Prevention and Tobacco Control Act (Pub. L. No. 111-31), which directed GAO to report on cross-border and illicit trade in tobacco products. Crossborder trade is defined in the Act as trade across a U.S. border, state, territory, or Indian country. Illicit trade is defined in the Act as any practice or conduct prohibited by law which relates to or facilitates the production, shipment, receipt, possession, distribution, sale, or purchase of tobacco products. This report is the first of two GAO products that will respond to this mandate. This report examines (1) incentives that are important for understanding cross-border and illicit trade in tobacco products; and (2) different schemes used to generate profits from cross-border and illicit trade in tobacco products. GAO interviewed government officials, industry representatives, and other subject matter experts. GAO collected and analyzed data from these sources and reviewed relevant literature.
Tobacco products face varying levels of taxation in different locations, creating opportunities and incentives for illicit trade. Cigarettes are taxed at the federal, state, and in some cases, local levels. According to industry representatives, taxes and other fees make up significant components of the final price of cigarettes, averaging 53 percent of the retail price. While the national average retail price of a pack of cigarettes was $5.95 in 2010, in New York City, a pack can cost up to $13.00 or more due to high combined state and city taxes. In contrast, a pack of cigarettes in Richmond, Virginia, can cost approximately $5.00, due to low state cigarette taxes there. The tax differential between a case of cigarettes (typically containing 12,000 cigarettes) in New York City and Richmond is over $3,000, creating incentives for illicit trade and profits. Excise taxes and other fees on tobacco products can be evaded at numerous points in the supply chain. Law enforcement officials told us another incentive to engage in this activity is the fact illicit tobacco penalties are comparatively less severe than other forms of illicit trade. According to experts we spoke with and literature we reviewed, a wide range of schemes are used by different actors to profit from illicit trade in tobacco products, mainly through the evasion of taxes. Schemes can range from individual consumers purchasing tax-free cigarettes from Internet Web sites, to larger-scale interstate trafficking of tobacco products, to smuggling cigarettes into the country by criminal organizations. For example: (1) A California distributor purchased approximately $1.4 million in other tobacco products (e.g., cigars and chewing tobacco) from an out-ofstate distributor, who disguised the shipments using falsified documents and black plastic wrapping. The California distributor then sold it to customers and failed to pay state excise taxes. (2) A criminal organization attempted to conceal two containers of counterfeit cigarettes and pass them through Customs at the Los Angeles/Long Beach port by declaring them as toys and plastic goods. (3) A manufacturer evaded Tobacco Master Settlement Agreement (MSA) escrow payments. The manufacturer underreported its cross-border sales to numerous states, including Virginia. By underreporting its sales to Virginia, the manufacturer evaded approximately $580,000 in escrow payments. Law enforcement officials reported that patterns of schemes are dynamic and identified links between illicit trade in tobacco and other crimes.
GAO-11-313, Illicit Tobacco: Various Schemes Are Used to Evade Taxes and Fees
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United States Government Accountability Office:
GAO:
Report to Congressional Committees:
March 2011:
Illicit Tobacco:
Various Schemes Are Used to Evade Taxes and Fees:
GAO-11-313:
GAO Highlights:
Highlights of GAO-11-313, a report to congressional committees.
Why GAO Did This Study:
Federal and state governments have raised excise taxes on tobacco
products to discourage tobacco use and increase revenues. Cross-border
and illicit trade in tobacco products can undermine these policy
objectives by avoiding excise taxes and increasing the availability of
these products to consumers at lower cost.
On June 22, 2009, Congress passed the Family Smoking Prevention and
Tobacco Control Act (Pub. L. No. 111-31), which directed GAO to report
on cross-border and illicit trade in tobacco products. Cross-border
trade is defined in the Act as trade across a U.S. border, state,
territory, or Indian country. Illicit trade is defined in the Act as
any practice or conduct prohibited by law which relates to or
facilitates the production, shipment, receipt, possession,
distribution, sale, or purchase of tobacco products. This report is
the first of two GAO products that will respond to this mandate.
This report examines (1) incentives that are important for
understanding cross-border and illicit trade in tobacco products; and
(2) different schemes used to generate profits from cross-border and
illicit trade in tobacco products. GAO interviewed government
officials, industry representatives, and other subject matter experts.
GAO collected and analyzed data from these sources and reviewed
relevant literature.
What GAO Found:
Tobacco products face varying levels of taxation in different
locations, creating opportunities and incentives for illicit trade.
Cigarettes are taxed at the federal, state, and in some cases, local
levels. According to industry representatives, taxes and other fees
make up significant components of the final price of cigarettes,
averaging 53 percent of the retail price. While the national average
retail price of a pack of cigarettes was $5.95 in 2010, in New York
City, a pack can cost up to $13.00 or more due to high combined state
and city taxes. In contrast, a pack of cigarettes in Richmond,
Virginia, can cost approximately $5.00, due to low state cigarette
taxes there. The tax differential between a case of cigarettes
(typically containing 12,000 cigarettes) in New York City and Richmond
is over $3,000, creating incentives for illicit trade and profits.
Excise taxes and other fees on tobacco products can be evaded at
numerous points in the supply chain. Law enforcement officials told us
another incentive to engage in this activity is the fact illicit
tobacco penalties are comparatively less severe than other forms of
illicit trade.
According to experts we spoke with and literature we reviewed, a wide
range of schemes are used by different actors to profit from illicit
trade in tobacco products, mainly through the evasion of taxes.
Schemes can range from individual consumers purchasing tax-free
cigarettes from Internet Web sites, to larger-scale interstate
trafficking of tobacco products, to smuggling cigarettes into the
country by criminal organizations. For example:
* A California distributor purchased approximately $1.4 million in
other tobacco products (e.g., cigars and chewing tobacco) from an out-
of-state distributor, who disguised the shipments using falsified
documents and black plastic wrapping. The California distributor then
sold it to customers and failed to pay state excise taxes.
* A criminal organization attempted to conceal two containers of
counterfeit cigarettes and pass them through Customs at the Los
Angeles/Long Beach port by declaring them as toys and plastic goods.
* A manufacturer evaded Tobacco Master Settlement Agreement (MSA)
escrow payments. The manufacturer underreported its cross-border sales
to numerous states, including Virginia. By underreporting its sales to
Virginia, the manufacturer evaded approximately $580,000 in escrow
payments.
Law enforcement officials reported that patterns of schemes are
dynamic and identified links between illicit trade in tobacco and
other crimes.
View [hyperlink, http://www.gao.gov/products/GAO-11-313] or key
components. For more information, contact Loren Yager at (202) 512-
4347 or YagerL@gao.gov.
[End of section]
Contents:
Letter:
Appendix I: Briefing Pages:
Background:
Incentives:
Schemes:
Appendix II: GAO Contacts and Staff Acknowledgments:
Abbreviations:
ATF: Bureau of Alcohol, Tobacco, Firearms, and Explosives:
CBP: Customs and Border Protection:
MSA: Master Settlement Agreement:
TTB: Alcohol and Tobacco Tax and Trade Bureau:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
March 7, 2011:
The Honorable Tom Harkin:
Chairman:
The Honorable Michael B. Enzi:
Ranking Member:
Committee on Health, Education, Labor, and Pensions:
United States Senate:
The Honorable Fred Upton:
Chairman:
The Honorable Henry A. Waxman:
Ranking Member:
Committee on Energy and Commerce:
House of Representatives:
Tobacco use is the leading cause of preventable death in the United
States and a significant contributor to health care costs in this
country. According to the Centers for Disease Control and Prevention,
smoking accounts for over 400,000 premature deaths per year--including
almost 50,000 deaths among nonsmokers due to second hand smoke--and
costs the United States an estimated $193 billion in health care
expenditures and loss of productivity. Past federal and state
legislation has aimed to discourage tobacco use and raise revenues by
increasing excise taxes on tobacco products. However, cross-border and
illicit trade in tobacco products can undermine these policy
objectives by avoiding taxes and increasing the availability of these
products to consumers at a lower cost, including youth smokers.
Illicit trade in tobacco products, according to U.S. law enforcement
agencies, is also a source of financing for both domestic and
international criminal activities.
In June 2009, Congress passed the Family Smoking Prevention and
Tobacco Control Act,[Footnote 1] with the purpose of granting the Food
and Drug Administration regulatory authority over the manufacture,
marketing, and distribution of tobacco products.[Footnote 2] The Act
also directed us to provide information on cross-border and illicit
trade in tobacco products, including the monitoring of such trade;
cross-border advertising of tobacco products; and the health effects
resulting from cross-border and illicit trade in tobacco products,
including the health effects from differing tax rates applicable to
tobacco products.[Footnote 3] The Act defined cross-border trade as
trade across the border of the United States, a State or Territory, or
Indian country.[Footnote 4]
This report examines (1) incentives that are important for
understanding cross-border and illicit trade in tobacco products; and
(2) the different schemes used to generate profits from cross-border
and illicit trade in tobacco products. The results of our work are
contained in appendix I. As discussed with your staff, we believe this
information about the industry structure and the incentives for
illegal trade as well as the different types of schemes used to
generate profits is essential to the evaluation and design of policy
measures that address illicit trade in those products.
In accordance with our agreement with the Senate Committee on Health,
Education, Labor, and Pensions, and the House Energy and Commerce
Committee, we will issue a second report in 2011 that will provide
additional information and findings on U.S. government efforts to
monitor cross-border and illicit trade in tobacco products and will
also address cross-border advertising and the health effects from
cross-border and illicit trade, as directed by the Act.
To address these objectives, we interviewed subject matter experts
with varying backgrounds and points-of-view in order to understand the
range of perspectives on illicit trade in tobacco products, including
discussions on industry characteristics and varying incentives and
methods of illicit trade, among other issues. Our criteria for
selecting experts included the type and depth of experience; for
instance, whether the expert had authored a widely referenced study or
article on the topic, and whether the expert was referred to us by at
least one other interviewee as someone knowledgeable about the topic.
In addition, we sought representation of relevant organizations and
sectors including, where applicable, representatives from government,
academia, industry, and professional organizations. The subject matter
experts we contacted included officials from the Departments of Health
and Human Services, Homeland Security, Justice, and Treasury; the
Federal Trade Commission and state agencies; representatives from
nongovernmental organizations and major tobacco manufacturers; as well
as other subject matter experts such as consultants and academics. We
conducted a literature review of studies and documents discussing
various aspects of cross-border and illicit trade in tobacco products,
including industry characteristics, taxation, distribution methods,
and the different types of illicit trade. We reviewed reports,
studies, and other documents from relevant U.S. agencies; multilateral
organizations, including the World Health Organization and the
Organization for Economic Cooperation and Development; industry;
nongovernment organizations; think tanks; and academic institutions.
For background purposes, we collected and analyzed tobacco industry
data, including data on value of shipments and market concentration by
product, manufacturer, and brand. We also obtained data from 2000 to
2010 on U.S. imports and exports of cigarettes and other tobacco
products, and on U.S. production and consumption of cigarettes. In
addition, we collected and analyzed secondary source data on federal
and state excise tax rates on cigarettes and changes in these rates
over time. We did not independently verify all tax rates included in
this product. We examined the reliability of data provided by industry
sources by interviewing representatives to discuss how the data were
collected and what checks or testing were performed on the data. For
government data, we reviewed recent data reliability assessments
conducted by GAO. In both cases, we found the data were sufficiently
reliable for background and contextual purposes and to address our
objectives. We traveled to Richmond, Virginia, to meet with industry
representatives, viewed manufacturing, distribution, and retail
facilities, and met with employees at these facilities. Because of its
clandestine nature, the extent of illicit trade in tobacco products
cannot be measured with certainty.
We conducted our work from May 2010 to March 2011 in accordance with
all sections of GAO's Quality Assurance Framework that are relevant to
our objectives. The framework requires that we plan and perform the
engagement to obtain sufficient and appropriate evidence to meet our
stated objectives and to discuss any limitations in our work. We
believe that the information and data obtained, and the analysis
conducted, provide a reasonable basis for any findings and conclusions.
We provided a draft of this report to the Assistant Attorney General,
the Secretary of Homeland Security, and the Secretary of the Treasury.
Staff from the Departments of Homeland Security, Justice, and Treasury
provided technical comments on this report and generally concurred
with our findings.
We are sending copies of this report to interested congressional
committees and to other interested parties. In addition, the report
will be available at no charge on GAO's Web site at [hyperlink,
http://www.gao.gov].
If you or your staff have any questions or wish to discuss the
material further, please contact me at (202) 512-4347 or
yagerl@gao.gov. Contact points for our offices of congressional
relations and Public Affairs may be found on the last page of this
report. Individuals who made key contributions to this report are
listed in Appendix II.
Signed by:
Loren Yager:
Director, International Affairs and Trade:
[End of section]
Appendix I: Briefing Pages:
Background:
Timeline of Key Legislative and Industry Events:
As seen in figure 1, federal laws focused on cross-border and illicit
trade in tobacco products date back to the Jenkins Act of 1949, which
established cigarette sales reporting requirements for state excise tax
collection (15 U.S.C. §§ 375-378). Over time, penalties for cigarette
trafficking and other crimes involving illicit trade have increased,
as have federal agencies‘ authorities. For instance, the USA PATRIOT
Improvement and Reauthorization Act of 2005 lowered the threshold
quantity for treatment of cigarettes as contraband from 60,000
cigarettes (300 cartons) to 10,000 cigarettes (50 cartons). Pub. L.
No. 109-177 (2006).
Several industry-related events also have impacted cross-border trade in
tobacco products. In 1998, 46 states signed the Master Settlement
Agreement (MSA) with the four largest U.S. tobacco companies to settle
state tobacco-related lawsuits and recover billions of dollars in costs
associated with smoking-related illnesses. In addition, the U.S. tobacco
industry‘s three major manufacturers, Philip Morris USA, R.J. Reynolds,
and Lorillard, sold or separated from their international businesses,
and now focus on the U.S. market.
Federal law enforcement officials stated that some large tobacco
manufacturers were previously implicated in illicit trade. For
example, in 1998 an R.J. Reynolds subsidiary pleaded guilty and paid
$15 million in federal fines for charges related to a scheme in which
Canadian-produced cigarettes were exported to the United States and
rerouted to Canada to avoid tax payments. However, these officials
stated that the large tobacco companies are now cooperating to address
tobacco diversion.
Figure 1: Timeline of Key Legislative and Industry Events:
[Refer to PDF for image: timeline]
Legislation:
1949:
Jenkins Act.
1970's:
Contraband Cigarette Trafficking Act.
2000:
Imported Cigarette Compliance Act.
2004:
American Jobs Creation Act (Tobacco buyout).
2006:
USA PATRIOT Improvement and Reauthorization Act.
2009:
Children's Health Insurance Program Reauthorization Act (Increase in
excise tax rate on tobacco products);
Family Smoking Prevention and Tobacco Control Act.
2010:
Prevent All Cigarette Trafficking Act.
Industry:
1970's:
Lorillard‘s international business acquired by British American
Tobacco.
1998:
MSA;
Northern Brands International (R.J. Reynolds subsidiary) pleaded
guilty to smuggling-related charges.
2008:
Philip Morris USA split from Philip Morris International.
Source: GAO analysis.
[End of figure]
Other Key Legislation:
* Imported Cigarette Compliance Act of 2000 prohibited importing
cigarettes into the United States bearing registered U.S. trademarks
without the trademark owner‘s authorization. Pub. L. No. 106-476.
* Children‘s Health Insurance Program Reauthorization Act of 2009
increased federal excise taxes on tobacco products, including raising
the tax on small cigarettes from $0.39 to $1.01 per pack, in order to
fund the State Children‘s Health Insurance Program. Pub. L. No. 111-3.
* Prevent All Cigarette Trafficking Act of 2009 amended the Jenkins
Act by revising provisions that govern the collection of taxes on
cigarettes and smokeless tobacco. Pub. L. No. 111-154 (2010). The
amendments included a requirement for Internet and other delivery
sellers to pay all applicable state and local excise taxes and affix
any related tax stamps before delivering any cigarettes or smokeless
tobacco products to any customer in a state. It also amended the
federal criminal code to treat cigarettes and smokeless tobacco as
nonmailable matter.
Background: Cigarettes Dominate the U.S. Tobacco Industry:
As shown in figure 2, cigarettes vastly outsold other tobacco products”
a category of tobacco products that includes cigars, chewing tobacco,
snuff, pipe tobacco, and roll-your-own tobacco. For example, in 2009,
cigarettes made up 80 percent of the value of tobacco product
shipments in the United States, while other tobacco products
collectively made up the remaining 20 percent of the market. However,
as can be seen in figure 2, other tobacco products‘ share of the
market has increased annually since 2007 as measured by the value of
shipments, which represents other tobacco products‘ share of the total
value of all tobacco products produced and shipped by all U.S.
producers for both domestic and export markets.
The total value of shipments for all tobacco products also steadily
declined during this time period. Total shipments decreased from a
high of $49.7 billion in 2001 to $29.4 billion in 2009. Due to
cigarettes‘ dominance of the tobacco industry, this report will focus
primarily on cigarettes, although some information pertaining to other
tobacco products will be covered.
Other tobacco products that have recently entered the U.S. market
include Snus”-a moist tobacco product contained in small pouches-”and
other products that dissolve and release nicotine when placed in the
mouth or on the tongue. Some officials have stated that the industry
may increasingly shift toward these types of products as cigarettes
are more heavily taxed and regulated, but information on the extent of
this trend is not yet available.
Figure 2: Tobacco Products by Value of Shipments (2000 – 2009):
[Refer to PDF for image: stacked vertical bar graph]
Year: 2000;
Cigarettes: $41.6 billion;
Other tobacco products: $4.0 billion.
Year: 2001;
Cigarettes: $45.7 billion;
Other tobacco products: $4.0 billion.
Year: 2002;
Cigarettes: $33.7 billion;
Other tobacco products: $4.1 billion.
Year: 2003;
Cigarettes: $33.3 billion;
Other tobacco products: $4.3 billion.
Year: 2004;
Cigarettes: $33.3 billion;
Other tobacco products: $4.3 billion.
Year: 2005;
Cigarettes: $36.9 billion;
Other tobacco products: $4.6 billion.
Year: 2006;
Cigarettes: $35.8 billion;
Other tobacco products: $4.6 billion.
Year: 2007;
Cigarettes: $34.1 billion;
Other tobacco products: $4.4 billion.
Year: 2008;
Cigarettes: $30.5 billion;
Other tobacco products: $5.2 billion.
Year: 2009;
Cigarettes: $23.5 billion;
Other tobacco products: $5.9 billion.
Source: GAO analysis of 2000-2009 Annual Survey of Manufactures data.
Note: The value of shipments is defined by the Department of
Commerce‘s Annual Survey of Manufactures as the total value of all
products shipped by all producers for both domestic and export
markets. For selected products, this can represent value of receipts,
value of production, or value of work done.
[End of figure]
As shown in figure 3, U.S. cigarette manufacturing is heavily
concentrated within the top three manufacturers-”Philip Morris USA,
R.J. Reynolds, and Lorillard”-which represented 84 percent of
cigarettes sold in 2009.
* Philip Morris USA is owned by parent company Altria, which also owns
U.S. Smokeless Tobacco Company (manufacturer of Skoal and Copenhagen)
and John Middleton (manufacturer of Black & Mild cigars).
* Reynolds American is the parent company for R.J. Reynolds Tobacco
Company and also owns the American Snuff Company (products include
Kodiak and Grizzly) and Santa Fe Natural Tobacco Company (manufacturer
of Natural American Spirit cigarettes).
* Lorillard, the nation‘s third-largest tobacco company, manufactures
Newport and other cigarette brands.
* The fourth- and fifth-largest manufacturers (Commonwealth Brands and
Liggett & Myers) together comprised approximately 7 percent of the
market.
As indicated in figure 4, Philip Morris USA‘s Marlboro is the leading
U.S. cigarette brand, followed by Newport (Lorillard), Camel, and Pall
Mall (both manufactured by R.J. Reynolds).
Figure 3: Cigarette Manufacturers by Number of Cigarettes in 2009:
[Refer to PDF for image: pie-chart]
Philip Morris USA: 47%;
R.J. Reynolds: 26%;
Lorillard: 11%;
Commonwealth Brands: 4%;
Liggett & Myers: 3%;
Other: 9%.
Source: GAO analysis of 2009 Tobacco Merchants Association data.
[End of figure]
Figure 4: Cigarette Brands by Number of Cigarettes in 2009:
[Refer to PDF for image: pie-chart]
Philip Morris USA:
Marlboro: 40%;
Basic: 3%.
R.J. Reynolds:
Camel: 7%;
Pall Mall: 5%;
Winston: 3%;
Doral: 3%;
Kool: 3%.
Lorillard:
Newport: 10%.
Other: 26%.
Source: GAO analysis of 2009 Tobacco Merchants Association data.
[End of figure]
U.S. Cigarette Exports Have Dropped Sharply:
Figure 5 shows trends in U.S. imports and exports for cigarettes and
other tobacco products from 2000 to 2010. U.S. cigarette exports
declined significantly, from $3.3 billion in 2000 to $373 million in
2010. As discussed earlier, the leading U.S. cigarette manufacturers
have split or sold their international businesses and now sell almost
exclusively in the U.S. market. Prior to these separations, U.S.
companies had expanded overseas production for international markets,
which also contributed to the decline in exports during this time
period. Reynolds American is the one exception among the leading
tobacco companies and manufactures its Natural American Spirit brand
cigarettes for export to Asian markets. An official from the
Department of the Treasury‘s Alcohol and Tobacco Tax and Trade Bureau
(TTB) reported that smaller manufacturers also continue to export
cigarettes.
The leading destination country for U.S. cigarette exports during this
period was Japan, which accounted for approximately 83 percent of U.S.
exports in 2010.
U.S. imports of cigarettes declined from $212 million in 2000 to $137
million in 2010. The top three source countries for U.S. cigarette
imports in 2010 were Canada, South Korea, and Turkey.
Figure 6 shows trends in U.S. production and consumption of cigarettes
from 2000 to 2010. Domestic production of cigarettes declined from 593
billion cigarettes in 2000 to 317 billion cigarettes in 2010, while
domestic consumption of cigarettes declined from 456 billion
cigarettes in 2000 to 299 billion cigarettes in 2010.
Figure 5: U.S. Imports and Exports of Cigarettes and Other Tobacco
Products by Value (2000 – 2010):
[Refer to PDF for image: multiple line graph]
Year: 2000;
Exports of cigarettes: $3.3 million;
Imports of cigarettes: $0.2 million;
Exports of other tobacco products: $0.7 million;
Imports of other tobacco products: $0.3 million.
Year: 2001;
Exports of cigarettes: $2.1 million;
Imports of cigarettes: $0.2 million;
Exports of other tobacco products: $0.6 million;
Imports of other tobacco products: $0.3 million.
Year: 2002;
Exports of cigarettes: $1.5 million;
Imports of cigarettes: $0.2 million;
Exports of other tobacco products: $0.5 million;
Imports of other tobacco products: $0.3 million.
Year: 2003;
Exports of cigarettes: $1.4 million;
Imports of cigarettes: $0.2 million;
Exports of other tobacco products: $0.4 million;
Imports of other tobacco products: $0.3 million.
Year: 2004;
Exports of cigarettes: $1.3 million;
Imports of cigarettes: $0.2 million;
Exports of other tobacco products: $0.3 million;
Imports of other tobacco products: $0.3 million.
Year: 2005;
Exports of cigarettes: $1.2 million;
Imports of cigarettes: $0.2 million;
Exports of other tobacco products: $0.1 million;
Imports of other tobacco products: $0.3 million.
Year: 2006;
Exports of cigarettes: $1.2 million;
Imports of cigarettes: $0.2 million;
Exports of other tobacco products: $0.1 million;
Imports of other tobacco products: $0.4 million.
Year: 2007;
Exports of cigarettes: $1.0 million;
Imports of cigarettes: $0.2 million;
Exports of other tobacco products: $0.1 million;
Imports of other tobacco products: $0.4 million.
Year: 2008;
Exports of cigarettes: $0.7 million;
Imports of cigarettes: $0.2 million;
Exports of other tobacco products: $0.1 million;
Imports of other tobacco products: $0.5 million.
Year: 2009;
Exports of cigarettes: $0.4 million;
Imports of cigarettes: $0.2 million;
Exports of other tobacco products: $0.7 million;
Imports of other tobacco products: $0.5 million.
Year: 2010;
Exports of cigarettes: $0.4 million;
Imports of cigarettes: $0.1 million;
Exports of other tobacco products: $0.1 million;
Imports of other tobacco products: $0.5 million.
Source: GAO analysis of International Trade Commission data.
[End of figure]
Figure 6: Production and Consumption of Cigarettes (2000 – 2010):
[Refer to PDF for image: multiple line graph]
Year: 2000;
Production: 593 billion;
Consumption: 456 billion.
Year: 2001;
Production: 563 billion;
Consumption: 444 billion.
Year: 2002;
Production: 532 billion;
Consumption: 425 billion.
Year: 2003;
Production: 499 billion;
Consumption: 401 billion.
Year: 2004;
Production: 494 billion;
Consumption: 397 billion.
Year: 2005;
Production: 490 billion;
Consumption: 395 billion.
Year: 2006;
Production: 488 billion;
Consumption: 391 billion.
Year: 2007;
Production: 450 billion;
Consumption: 374 billion.
Year: 2008;
Production: 397 billion;
Consumption: 351 billion.
Year: 2009;
Production: 337 billion;
Consumption: 319 billion.
Year: 2010;
Production: 317 billion;
Consumption: 299 billion.
Source: GAO analysis of Tobacco Merchants Association data.
[End of figure]
Cigarettes Are Sold Through Supply Chains with Multiple Entities:
Cigarette manufacturers must obtain a permit to operate from TTB.
Manufacturers pay the federal excise tax for cigarettes to TTB on a
semimonthly basis, and the tax liability is imposed when cigarettes
leave the manufacturing facilities that are bonded with TTB. According
to TTB, there were 40 permitted cigarette manufacturers in 2010.
After the manufacturer pays the federal excise tax, it generally ships
the cigarettes to public warehouses or distributors. State and local
excise taxes are generally paid by wholesalers or distributors through
the purchase of excise tax stamps from state or local taxing
jurisdictions.
Manufacturers are not required to pay the federal excise tax for
direct or indirect exports. Indirect exports can be moved through a
foreign trade zone, export warehouse, or Customs-bonded warehouse,
such as a dutyfree store. Foreign trade zones are secured areas
usually located in or adjacent to Department of Homeland Security‘s
Customs and Border Protection (CBP) Ports of Entry where products are
not subject to U.S. duty or excise tax. Export warehouses are
permitted and bonded by TTB for storing tobacco products prior to
exportation.
Imports can also be direct or indirect. With direct importation,
cigarettes are cleared through U.S. Customs after duties and excise
taxes are paid upon the filing of the consumption entry. Indirect
imports can be cleared through Customs for delivery through a Customs-
bonded warehouse or a foreign trade zone. Duties and taxes are
deferred until the product is withdrawn from the warehouse or
foreign trade zone for consumption into the commerce of the United
States.
Figure 7 presents a simplified supply chain for the movement of
cigarettes through the legal market, highlighting the major steps in the
process and the key points at which taxes and fees are paid. Federal
excise taxes are paid by manufacturers when the products leave their
facilities, while state and local excise taxes are paid by wholesalers
or distributors. Supply chains can differ by manufacturer, and this
figure does not represent all of the steps in the distribution process.
Figure 7: Supply Chain for Legal Cigarettes:
[Refer to PDF for image: illustration]
Legal supply chain:
Manufacture:
* Export (tax-free);
Pays Federal Excise Tax:
Wholesale/Distribution:
Pays State/Local Tax:
Retail/Consumption.
Import: to Wholesale/Distribution:
Pays Federal Excise Tax and Duties.
Source: GAO analysis.
[End of figure]
As indicated in figure 8, cigarettes are typically packaged in groups
of 20 per pack and then assembled into cartons containing 10 packs, or
200 cigarettes. Domestic cases typically contain 60 cartons, or 12,000
cigarettes, although some manufacturers may vary the number of
cartons in a case. International cases typically contain 10,000
cigarettes.
Figure 8: Number of Cigarettes in a Pack, Carton and Domestic Case:
[Refer to PDF for image: illustrated table]
Size: Pack;
Number of cigarettes: 20.
Size: Carton;
Number of cigarettes: 200.
Size: Case;
Number of cigarettes: 12,000.
Source: GAO analysis.
[End of figure]
[End of Background section]
Incentives:
Cigarette Retail Prices Are Based Largely on Taxes and Other Fees:
The average retail price for a pack of premium cigarettes in 2010 was
$5.95. According to industry representatives, taxes and other fees
made up an average of 53 percent of the retail price of a pack of
cigarettes, including 34 percent for federal, state, and municipal
excise taxes and 19 percent for tobacco settlement payments.
In addition to taxes, cigarette retail prices include MSA payments made
by manufacturers. The three original participating manufacturers and
more than 45 subsequent participating manufacturers make annual
payments to MSA states. According to the National Association of
Attorneys General, these payments currently total approximately $7
billion per year. The 46 MSA-settling states also require
nonparticipating manufacturers, which have not signed on to the
agreement, to make payments into an escrow account according to a
separate formula. Four states (Florida, Minnesota, Mississippi, and
Texas) settled their cases separately from the MSA-settling states and
are, thus, not signatories to the MSA. These four states receive
settlement payments from original participating manufacturers, but do
not have statutes requiring escrow payments to be made by
nonparticipating manufacturers.
According to the National Association of Attorneys General, the market
share of nonparticipating manufacturers increased from less than one-
half of 1% prior to the MSA to almost 6% in 2009.
The tobacco industry differs from many other industries in that taxes
make up the major component of the retail price for its products. This
is especially true for cigarettes. Figure 9 provides a breakdown of the
various components of the retail price of a pack of premium cigarettes
in New York City that was domestically manufactured. Although prices
vary at different retail outlets, New York City consumers can pay up
to $13.00 or more for a pack of cigarettes. The state and city
cigarette taxes make the retail price of cigarettes in New York City
among the highest in the country.
Figure 9: Price Components of a $13.00 Cigarette Pack in New York, New
York, in 2010:
[Refer to PDF for image: illustration]
$4.91: Manufacturing, shipping, and mark-up;
$0.06 Tobacco buyout (fee);
$0.56 Escrow/MSA (fee);
$0.61 Personal property tax (sales tax);
$1.50 Local excise tax;
$4.35 State excise tax;
$ 1.01 Federal excise tax;
Taxes and fees: 62%.
Source: GAO analysis of New York City Department of Finance, National
Association of Attorneys General, and Altria data.
Notes:
(1) The Tobacco Transition Payment Program (Tobacco Buyout) provides
transition payments to tobacco quota holders and producers funded
through assessments on tobacco product manufacturers and importers. The
program was established in 2004 by Congress following the elimination
of the tobacco quota program, a tobacco price support program designed
to support and stabilize prices for tobacco farmers. See Pub. L. No.
108-357, Title VI, 118 Stat. 1521. Payments began in 2005 and will
continue through 2014. This fee is represented in figure 9.
(2) The Family Smoking Prevention and Tobacco Control Act also
established a user fee that is collected from manufacturers and
importers of tobacco products, including cigarettes, for the purpose
of paying costs related to the Food and Drug Administration‘s
regulation of tobacco products. See Pub. L. No. 111-31, Div A, §§
101(b)(3), 123 Stat. 1826-27. This user fee is not represented in
figure 9.
[End of figure]
Cigarette Packs Are Taxed at Varying Rates at the State Level:
State excise tax rates on cigarettes vary widely, which can create
incentives for criminals to engage in cross-border and illicit schemes
to profit or take advantage of these tax rate differentials. Figure 10
identifies states with high-, medium-, and low-tax rates for 2010, and
shows the range of state tax rates per pack, varying from $4.35 in New
York to $0.17 in Missouri. The map also illustrates how low-tax states
can become an attractive source of cheaper cigarettes for residents of
higher-tax states.
Figure 10: State Cigarette Excise Tax Rates by Pack in 2010:
[Refer to PDF for image: illustrated U.S. map]
State excise tax range: High ($1.70 and above):
New York: $4.35;
Rhode Island: $3.46;
Washington: $3.03;
Connecticut: $3.00;
Hawaii: $3.00;
New Jersey: $2.70;
Wisconsin: $2.52;
Massachusetts: $2.51;
District of Columbia: $2.50;
Vermont: $2.24;
Alaska: $2.00;
Arizona: $2.00;
Maine: $2.00;
Maryland: $2.00;
Michigan: $2.00;
New Hampshire: $1.78;
Utah: $1.70;
Montana: $1.70.
State excise tax range: Medium ($0.84 – $1.66):
New Mexico: $1.66;
Delaware: $1.60;
Pennsylvania: $1.60;
Minnesota: $1.58;
South Dakota: $1.53;
Texas: $1.41;
Iowa: $1.36;
Florida: $1.34;
Ohio: $1.25;
Oregon: $1.18;
Arkansas: $1.15;
Oklahoma: $1.03;
Indiana: $1.00;
Illinois: $0.98;
California: $0.87;
Colorado: $0.84.
State excise tax range: Low ($0.17 – $0.80):
Nevada: $0.80;
Kansas: $0.79;
Mississippi: $0.68;
Nebraska: $0.64;
Tennessee: $0.62;
Kentucky: $0.60;
Wyoming: $0.60;
Idaho: $0.57;
South Carolina: $0.57;
West Virginia: $0.55;
North Carolina: $0.45;
North Dakota: $0.44;
Alabama: $0.43;
Georgia: $0.37;
Louisiana: $0.37;
Virginia: $0.36;
Missouri: $0.17.
Sources: GAO analysis of Campaign for Tobacco-Free Kids data and Map
Resources (map).
[End of figure]
Cigarette Excise Tax Rates Have Increased in Recent Years:
According to the Campaign for Tobacco-Free Kids, states, the District
of Columbia, and U.S. territories have raised cigarette excise tax
rates more than 100 times since 2002, and 29 states have passed more
than one tax increase during that time period. For example, New York
raised its state tax rate from $1.11 to $1.50 in 2002, to $2.75 in
2008, and to $4.35 in 2010.
In addition to state taxes, a number of local jurisdictions also have
instituted excise taxes on cigarettes and have increased these tax rates
in recent years. According to the Tax Burden on Tobacco,1 nearly 520
cities, towns, and counties impose cigarette excise taxes. Municipal
cigarette excise taxes were levied in eight states during fiscal year
2009, ranging from $0.01 to $2.00 per pack. By the end of fiscal year
2009, local jurisdictions received an estimated $501 million from
their local cigarette excise taxes.
New York City has the highest combined state-local cigarette tax rate
with its city tax of $1.50 and state tax of $4.35, totaling $5.85 per
pack. Other locations with high combined state-local cigarette taxes
include Anchorage, Alaska, (city tax - $2.21, state tax - $2.00
totaling $4.21 per pack), and Chicago, Illinois, (city tax - $0.68,
county tax - $2.00, and state tax - $0.98, totaling $3.66 per pack).
The federal excise tax on cigarettes dates to 1864, when it was as low
as $0.08 per pack. The tax has increased 21 times since then,
including increases from $0.08 to $0.16 in 1983, from $0.24 to $0.34 in
2000, and the 2009 increase from $0.39 to $1.01.
State cigarette excise tax rates have increased over time, and figure 11
shows the trends for the high-, median-, and low-state tax rates since
2000. The states representing the highest, median, and lowest cigarette
excise tax rates have changed over time. For example, New York,
Massachusetts, New Jersey, and Rhode Island each had the highest tax
rate for at least 1 year since 2000.
Figure 11: State Cigarette Excise Tax Rates from Fiscal Year 2000 to
2010:
[Refer to PDF for image: multiple line graph]
Dollars per pack:
Fiscal year: 2000;
Highest: $1.11;
Median: $0.34;
Lowest: $0.03.
Fiscal year: 2001;
Highest: $1.11;
Median: $0.34;
Lowest: $0.03.
Fiscal year: 2002;
Highest: $1.50;
Median: $0.34;
Lowest: $0.03.
Fiscal year: 2003;
Highest: $1.51;
Median: $0.56;
Lowest: $0.03.
Fiscal year: 2004;
Highest: $2.05;
Median: $0.60;
Lowest: $0.03.
Fiscal year: 2005;
Highest: $2.46;
Median: $0.70;
Lowest: $0.05.
Fiscal year: 2006;
Highest: $2.46;
Median: $0.80.
Lowest: $0.07.
Fiscal year: 2007;
Highest: $2.58;
Median: $0.87;
Lowest: $0.07.
Fiscal year: 2008;
Highest: $2.75;
Median: $1.00;
Lowest: $0.07.
Fiscal year: 2009;
Highest: $3.46;
Median: $1.15;
Lowest: $0.07.
Fiscal year: 2010;
Highest: $4.35;
Median: $1.34;
Lowest: $0.17.
Source: GAO analysis of Tax Burden on Tobacco data.
[End of figure]
In addition, figure 12 shows that the federal cigarette excise tax rate
increased two times since 2000, including a sharp increase in 2009 as a
result of the Children‘s Health Insurance Program Reauthorization Act.
Figure 12: Federal Cigarette Excise Tax Rates from Fiscal Year 2000 to
2010:
[Refer to PDF for image: line graph]
Dollars per pack:
Fiscal year: 2000;
Federal Excise Tax Rate: $0.34.
Fiscal year: 2001;
Federal Excise Tax Rate: $0.34.
Fiscal year: 2002;
Federal Excise Tax Rate: $0.39.
Fiscal year: 2003;
Federal Excise Tax Rate: $0.39.
Fiscal year: 2004;
Federal Excise Tax Rate: $0.39.
Fiscal year: 2005;
Federal Excise Tax Rate: $0.39.
Fiscal year: 2006;
Federal Excise Tax Rate: $0.39.
Fiscal year: 2007;
Federal Excise Tax Rate: $0.39.
Fiscal year: 2008;
Federal Excise Tax Rate: $0.39.
Fiscal year: 2009;
Federal Excise Tax Rate: $1.01.
Fiscal year: 2010;
Federal Excise Tax Rate: $1.01.
159% federal excise tax increase.
Source: GAO analysis of Tax Burden on Tobacco data.
[End of figure]
Markets for Other Tobacco Products Shifted Following Changes in
Differing Federal Excise Tax Rates:
According to experts we interviewed, differing tax rates on tobacco
products can create incentives for the tobacco industry to shift
toward the manufacture or import of tobacco products with lower tax
rates for price-sensitive consumers. Some experts also stated that it
may be difficult for regulatory officials to differentiate between
tobacco products and the tobacco industry may blur the lines between
similar types of tobacco products to avoid higher tax rates. For
example, pipe tobacco may be marketed and produced with only minimal
differences from roll-your-own tobacco in order to take advantage of
the lower tax rate on pipe tobacco. However, TTB officials noted that
many shifts in the tobacco market due to differing tax rates are legal
as long as those tobacco products meet the definitions provided in the
Internal Revenue Code.
Historically, cigarettes were taxed at a higher rate than small cigars.
As a result, some consumers substituted small cigars for cigarettes,
according to an expert. However, the price difference between the two
products was reduced when the federal government imposed higher but
equivalent federal excise tax rates on cigarettes and small cigars in
April 2009.
Tax rates on large cigars, which are dependent upon the sale price,
were also raised at that time. However, according to TTB, the effect
of this raise created an incentive for manufacturers to produce large
cigars.
The federal excise tax on roll-your-own tobacco increased significantly
from $1.0969 per pound to $24.78 per pound in 2009, while the federal
excise tax on pipe tobacco increased at a much lower rate, from $1.0969
per pound to $2.8311 per pound. This large differential in excise tax
rate changes led to a large market shift from roll-your-own tobacco to
pipe tobacco, as measured by weight (see figure 13).
Figure 13: Market Shift Toward Pipe Tobacco Following Sharp Increase
in Federal Excise Taxes on Roll-Your-Own Tobacco:
[Refer to PDF for image: 2 pie-charts]
Weight:
Year prior to April 1, 2009:
Pipe tobacco (federal excise tax increase of $1.73/pound): 12.9%;
Roll-your-own tobacco (federal excise tax increase of $23.68/pound):
87.1%.
Year following April 1, 2009:
Pipe tobacco (federal excise tax increase of $1.73/pound): 65.0%;
Roll-your-own tobacco (federal excise tax increase of $23.68/pound):
35.0%.
Source: GAO analysis of TTB data.
[End of figure]
When the federal excise tax was raised on cigarettes from $19.50 per
thousand to $50.33 per thousand in 2009, it was also increased
significantly on small cigars from $1.828 per thousand to $50.33 per
thousand. Tax rates on large cigars were also raised, but the
resulting tax structure created an incentive for producers to modify
products to qualify as large cigars according to TTB. Figure 14 shows
a market shift toward large cigars after April 2009.
Figure 14: Market Shift Toward Large Cigars Following Respective
Increases in Federal Excise Taxes on Small and Large Cigars:
[Refer to PDF for image: 2 pie-charts]
Value of shipments:
Year prior to April 1, 2009:
Large cigars (155% increase in federal excise tax): 47.5%;
Small cigars (2653% increase in federal excise tax): 52.5%.
Year following April 1, 2009:
Large cigars (155% increase in federal excise tax): 88.7%;
Small cigars (2653% increase in federal excise tax): 11.3%.
Source: GAO analysis of TTB data.
Note: Tax increase on large cigars subject to a maximum of $0.4026 per
cigar.
[End of figure]
Illicit Tobacco Trade Offers High Rewards, Low Risks in Comparison to
Other Crimes:
According to a Department of the Treasury report to Congress, the
diversion of tobacco products occurs for two principal reasons: the
potential for illicit gains is high and the risk to illegal operators is
low. Substantial illicit profit can be derived by selling cigarettes on
which taxes have not been paid, particularly since the cost to produce
the product is minimal compared to the cost at which it is legally
sold.
In terms of risk for illegal operators, tobacco is a legal commodity
and can be transported and sold on the open market, making it simple
to establish a supply source and distribution channels. In addition,
tobacco products are an easy commodity to move in large quantities.
Furthermore, according to a Department of Justice Office of the
Inspector General report on the Bureau of Alcohol, Tobacco, Firearms,
and Explosives (ATF), tobacco diversion is attractive to criminals
because it can provide large profits and the criminal penalties are
less than the penalties for smuggling drugs.
While both imported and domestically produced cigarettes offer
incentives for illicit profits, the ease and convenience of
transporting cigarettes across state borders can offer opportunities for
profits without some of the difficulties of bringing them across the
U.S. border.
Illicit trade in tobacco products offers high rewards when taxes can be
evaded. The tax differentials between higher-tax states and lower-tax
states can increase the incentives. Figure 15 illustrates the tax
differentials between New York City and Richmond, Virginia, by type of
packaging. This differential provides an incentive to purchase
cigarettes in Richmond, Virginia, for illegal resale in New York City,
with a potential illicit profit of up to $3,330 per case.
Figure 15: Tax Differentials for a Pack, Carton, and Domestic Case
Between New York, New York, and Richmond, Virginia, 2010:
[Refer to PDF for image: illustrated table]
New York City:
Pack: $6.86;
Carton: $68.60;
Case: $4,116.00.
Richmond:
Pack: $1.31;
Carton: $13.10;
Case: $786.00.
Differential:
Pack: $5.55;
Carton: $55.50;
Case: $3,330.00.
Source: GAO analysis.
[End of figure]
Opportunities to Evade Excise Taxes and Fees at Multiple Points in
the Supply Chain:
As can be seen in the legal market section of figure 16, there are
multiple opportunities to divert tobacco products from the supply
chain in the legal market into the black market before all the
appropriate excise taxes and fees are collected. For example, there
are some opportunities to divert tobacco products from a retailer in
one state after appropriate excise taxes have been paid. In these
cases, the tobacco products can be purchased in a state with low
excise taxes, like Virginia, and then illegally transported cross-
border for illicit resale in a state with higher excise taxes, like
New York. Individual consumers can also make cross-border purchases in
states with lower excise taxes, an activity prohibited by some states
depending on the amount purchased.
Some tobacco products are never legal in the U.S. market, including
illegally manufactured and smuggled tobacco products. According to ATF
officials, distribution of tobacco products in the black market
generally mirrors distribution in the legal market.
Figure 16: Opportunities to Divert Tobacco Products into the Black
Market:
[Refer to PDF for image: illustration]
Legal Market:
Manufacture:
* Export (tax-free);
Pays Federal Excise Tax:
Wholesale/Distribution:
Pays State/Local Tax: or, Tax-free sales to retailers/consumers
in Indian country:
Retail/Consumption.
Import: to Wholesale/Distribution:
Pays Federal Excise Tax and Duties.
Black Market:
Illicit supply chain:
Illegal Manufacture:
Export;
Illegal distribution;
Illegal Retail/consumption.
Import:
Illegal distribution;
Illegal Retail/consumption.
Source: GAO analysis.
Note: Theft of tobacco products can also occur at any point in the
supply chain and is not represented on this supply chain graphic. The
graphic also does not represent legal manufacturing on Indian country
that may by-pass federal and state excise taxes.
[End of figure]
[End of Incentives section]
Schemes:
A Myriad of Schemes Are Used to Evade Taxes and Other Fees on
Tobacco Products:
Illicit trade schemes can originate at each point in the tobacco
supply chain. Figure 17 gives examples of some illicit schemes,
identifies their relationship to the supply chain, and indicates the
taxes and fees that can be avoided using each scheme. Schemes that
avoid federal excise taxes originate earlier in the supply chain.
Federal law enforcement officials identified state governments as key
stakeholders because many schemes evade state excise taxes. Schemes
can also result in the evasion of MSA or escrow payments, depending on
the manufacturer, tobacco product, and state involved.
According to federal and state law enforcement officials and experts,
the patterns of smuggling and diversion schemes are not static, but
change in response to many factors, including changes in tobacco
taxes, tobacco regulations, and law enforcement activity. Officials
characterized illicit trade in tobacco products as like a whack-a-
mole problem, stating that although illicit trade may decrease
immediately following successful law enforcement efforts, these
activities usually resume after a period of time. ATF officials also
noted that illicit trade in tobacco is often connected to other crime
and criminals may use proceeds from illicit trade in tobacco to
fund other crimes.
Figure 17: Illicit Trade Schemes Profit by Evading Taxes and Fees:
[Refer to PDF for image: illustrated table]
Relationship to supply chain: Import;
Examples of illicit trade schemes:
* Smuggling genuine or counterfeit cigarettes into the United States;
* Purchasing cigarettes from foreign Internet Web sites without
appropriate payment of tax;
Taxes and fees avoided: Customs duty: [Check];
Taxes and fees avoided: Federal excise tax: [Check];
Taxes and fees avoided: State/local excise tax: [Check];
Taxes and fees avoided: MSA/escrow payment: [Check].
Relationship to supply chain: Export;
Examples of illicit trade schemes:
* Diverting export-only cigarettes into U.S. commerce;
Taxes and fees avoided: Customs duty: N/A;
Taxes and fees avoided: Federal excise tax: [Check];
Taxes and fees avoided: State/local excise tax: [Check];
Taxes and fees avoided: MSA/escrow payment: [Check].
Relationship to supply chain: Manufacture;
Examples of illicit trade schemes:
* Manufacturing cigarettes in the United States without a license;
* Underreporting cigarette production to federal government;
Taxes and fees avoided: Customs duty: N/A;
Taxes and fees avoided: Federal excise tax: [Check];
Taxes and fees avoided: State/local excise tax: [Check];
Taxes and fees avoided: MSA/escrow payment: [Check].
Relationship to supply chain: Wholesale/distribution;
Examples of illicit trade schemes:
* Purchasing tobacco products from wholesaler in one state for illegal
transportation and resale in another state;
* Underreporting tobacco product sales to state governments;
Taxes and fees avoided: Customs duty: N/A;
Taxes and fees avoided: Federal excise tax: Paid;
Taxes and fees avoided: State/local excise tax: [Check];
Taxes and fees avoided: MSA/escrow payment: [Check].
Relationship to supply chain: Retail;
Examples of illicit trade schemes:
* Purchasing tobacco products from retailer in one state for illegal
transportation and resale in another state;
* Purchasing cigarettes in Indian country for resale to nontribal
members;
* Purchasing cigarettes from domestic Internet Web sites without
appropriate payment of tax;
Taxes and fees avoided: Customs duty: N/A;
Taxes and fees avoided: Federal excise tax: Paid;
Taxes and fees avoided: State/local excise tax: [Check];
Taxes and fees avoided: MSA/escrow payment: [Check].
Relationship to supply chain: Other;
Examples of illicit trade schemes:
* Underreporting cigarette sales to MSA states;
Taxes and fees avoided: Customs duty: N/A;
Taxes and fees avoided: Federal excise tax: Paid;
Taxes and fees avoided: State/local excise tax: Paid;
Taxes and fees avoided: MSA/escrow payment: [Check].
Source: GAO analysis.
Note: In some wholesale/distribution and retail schemes, state excise
taxes are paid in the state where the tobacco products are purchased,
but unpaid in the state where the tobacco products are illicitly
resold.
[End of figure]
Smuggling Genuine and Counterfeit Tobacco Products:
Smuggling:
According to officials from CBP and U.S. Immigration and Customs
Enforcement, smugglers have illegally imported cigarettes into the
United States by not declaring them at Customs, disguising them, and
hiding them behind other commodities.
Officials also described schemes in which one type of tobacco product
may be misclassified as another type of tobacco product with a more
favorable federal excise tax and rate of duty. For example, CBP
officials noted that it is difficult to distinguish between roll-your-
own tobacco and pipe tobacco. Also, roll-your-own tobacco imports can
be misclassified as pipe tobacco to evade the higher federal excise
taxes on roll-your-own.
According to an official from Immigration and Customs Enforcement,
tobacco products may also be smuggled into the United States through
the Customs in-bond system by falsifying manifests. In addition, ATF
officials stated that an investigation has targeted smuggling through a
foreign trade zone.
An official from TTB also noted that large amounts of cigarettes
purchased from foreign-based Internet Web sites are brought into the
United States without the payment of federal excise taxes.
Relationship to supply chain: Import;
Examples of illicit trade schemes:
* Smuggling genuine or counterfeit cigarettes into the United States;
* Purchasing cigarettes from foreign Internet Web sites without
appropriate payment of tax;
Taxes and fees avoided: Customs duty: [Check];
Taxes and fees avoided: Federal excise tax: [Check];
Taxes and fees avoided: State/local excise tax: [Check];
Taxes and fees avoided: MSA/escrow payment: [Check].
Source: GAO analysis.
A range of schemes have been used to evade duties and excise taxes on
both genuine and counterfeit tobacco products as they are imported into
the United States and distributed in the black market. According to CBP
officials, smugglers have imported counterfeit tobacco products by
falsely declaring them as other commodities. For example, a recent CBP
press release revealed that more than 22,000 cartons of counterfeit
Marlboros were intercepted after being shipped from China and seized at
the Los Angeles/Long Beach seaport complex. The counterfeit cigarettes,
pictured in figure 18, were falsely declared as hang tags and hang
plugs.
Figure 18: Seizure of Counterfeit Cigarettes:
[Refer to PDF for image: photograph]
Source: CBP.
[End of figure]
In another case, ATF investigated the unlawful sales of cigarettes
through a foreign-based Internet Web site. ATF‘s records stated
approximately 156,000 cigarette orders packaged for delivery to
persons across the United States were seized. ATF estimated that
losses in federal and state tax revenue resulting from this illegal
operation exceeded $425 million.
Diverting Cigarettes Manufactured for Export:
Export Diversion:
Officials from ATF and TTB reported that cases targeting the diversion
of export-only cigarettes into U.S. commerce are currently being
investigated. Domestically manufactured cigarettes may be exported
without the payment of federal excise taxes. However, these cigarettes
must bear an export mark such as ’U.S. Tax Exempt For Use Outside U.S.“
According to experts we spoke with, export diversion may be less
prevalent following the decline in cigarettes produced for export by
the three largest cigarette manufacturers. However, smaller
manufacturers still produce cigarettes for export and an expert told
us that export-diversion schemes may be shifting to cigarettes
produced by these smaller manufacturers.
Cigarettes and other tobacco products can also be smuggled from the
United States into foreign countries.
Relationship to supply chain: Export;
Examples of illicit trade schemes:
* Diverting export-only cigarettes into U.S. commerce;
Taxes and fees avoided: Customs duty: N/A;
Taxes and fees avoided: Federal excise tax: [Check];
Taxes and fees avoided: State/local excise tax: [Check];
Taxes and fees avoided: MSA/escrow payment: [Check].
Source: GAO analysis.
Individuals may illegally divert cigarettes manufactured for export from
the United States for illicit resale in the United States and evade
federal excise taxes as a result. In one case, a criminal organization
purchased large quantities of cigarettes labeled for export in Miami
and illegally introduced them into U.S. commerce after presenting
false documents, including fraudulent Mexican documents, to CBP
reflecting that the cigarettes had been exported to Mexico. In
reality, the contraband cigarettes had been diverted and sold to
customers in New York without the payment of federal or state excise
taxes. Figure 19 provides an example of cigarette packs with and
without export markings.
Figure 19: Packs of Domestically Manufactured Cigarettes With and
Without Export Marking:
[Refer to PDF for image: photograph]
Source: Department of Homeland Security.
Note: Pack without marking is on left. Packs with markings are center
and right.
[End of figure]
Diverting Domestically Manufactured Cigarettes:
Unlicensed Manufacturing:
According to an official from TTB, unlicensed manufacturing is one of
two primary illicit manufacturing schemes used to evade taxes on
domestically produced cigarettes. In general, unlicensed manufacturers
do not submit tax returns and monthly reports to TTB, nor do they pay
federal excise taxes on the cigarettes they produce.
Underreporting Production:
The other primary illicit manufacturing scheme, according to a TTB
official, is underreporting on tax returns the amount of domestically
produced cigarettes that leave a manufacturing facility bonded with
TTB. Tax returns form the basis of the federal excise tax payments and
underreporting the amount of cigarettes subject to tax results in the
evasion of federal excise taxes.
Relationship to supply chain: Manufacture;
Examples of illicit trade schemes:
* Manufacturing cigarettes in the United States without a license;
* Underreporting cigarette production to federal government;
Taxes and fees avoided: Customs duty: N/A;
Taxes and fees avoided: Federal excise tax: [Check];
Taxes and fees avoided: State/local excise tax: [Check];
Taxes and fees avoided: MSA/escrow payment: [Check].
Source: GAO analysis.
According to many government officials and experts, most unlicensed
cigarette manufacturing occurs in northern New York on land controlled
by the St. Regis Mohawk tribe. A New York official estimates that there
are between 15 and 18 unlicensed cigarette manufacturers on this land.
According to TTB officials, only two of the unlicensed manufacturers
have permit applications pending with TTB. Most of these unlicensed
cigarette manufacturers produce ’rollies“ or ’baggies,“ containing 200
cigarettes, as shown in figure 20. According to an U.S. Immigration and
Customs Enforcement official, these packages may sell for as little as
$20. This price is significantly less than a carton of premium brand
cigarettes that can sell for over $100 in New York City.
Figure 20: Illicit Cigarettes on Land Controlled by the St. Regis
Mohawk Tribe:
[Refer to PDF for image: photograph]
Source: TTB.
In a recent case involving a licensed cigarette manufacturer, the
manufacturer evaded federal excise taxes by submitting false tax returns
and monthly reports to TTB that underreported the quantity of cigarettes
removed from its factory. According to court documents, the
manufacturer failed to include nearly 2.45 million packs of cigarettes
on its tax returns and reports, resulting in the evasion of $950,000
in federal excise taxes.
Diverting Tobacco Products During Distribution:
Interstate Trafficking:
According to federal and state law enforcement officials, there are
many different types of diversion schemes at the wholesale and
distribution level of the supply chain. ATF officials stated that
criminal organizations may purchase state excise tax-paid cigarettes
from wholesalers in a state with low state excise taxes, like
Virginia, and illegally transport those cigarettes for resale in a state
with higher excise taxes, like New York, to capitalize on state excise
tax differentials.
Another pattern of interstate diversion entails purchasing cigarettes
from a wholesaler in a state that does not use tax stamps to indicate
the payment of excise taxes on cigarettes, like North Carolina, South
Carolina, or North Dakota, and transporting those cigarettes for
resale in a state with higher excise taxes. Counterfeit tax stamps may
then be applied to these contraband cigarettes before they are resold
to deceive both authorities and consumers.
State law enforcement officials have also cited the interstate
diversion of other tobacco products, like cigars or smokeless tobacco,
as an increasing concern. Other tobacco products are not stamped when
taxes are paid.
Underreporting Sales:
Federal and state law enforcement officials reported that wholesalers
and distributors can also evade state excise taxes on cigarettes and
other tobacco products by falsifying their reports to state
governments, including overstating tax-exempt out-of-state sales, or by
neglecting to submit the required reports.
Relationship to supply chain: Wholesale/distribution;
Examples of illicit trade schemes:
* Purchasing tobacco products from wholesaler in one state for illegal
transportation and resale in another state;
* Underreporting tobacco product sales to state governments;
Taxes and fees avoided: Customs duty: N/A;
Taxes and fees avoided: Federal excise tax: Paid;
Taxes and fees avoided: State/local excise tax: [Check];
Taxes and fees avoided: MSA/escrow payment: [Check].
Source: GAO analysis.
Many distribution schemes involve wholesalers and distributors evading
state excise taxes on cigarettes or other tobacco products by falsifying
their reports to state governments. In a recent California case, for
example, distributors of other tobacco products conspired to sell in the
state without paying California state excise taxes. The distributors did
not accurately report their sales to the California state government and
evaded an estimated $650,000 in state excise taxes. According to the
Office of the United States Attorney, more than $35 million in
California state excise taxes have been evaded by other tobacco products
distributors using a number of schemes, including either failing to
submit excise tax returns or submitting fraudulent returns, falsifying
other commercial documents like invoices, and using dummy corporations
or out-of-state distributors to deceive state authorities. Figure 21
shows a distributor‘s warehouse with other tobacco products that was
seized in connection to these cases.
Figure 21: Other Tobacco Products in Warehouse Seized in Connection with
California State Excise Tax Evasion:
[Refer to PDF for image: 2 photographs]
Sources: ATF and California State Board of Equalization.
[End of figure]
Diverting Tobacco Products Sold at Retail:
Interstate Trafficking:
Similar to diversion at the wholesale level, tobacco products at the
retail level are diverted to capitalize on differentials between state
excise taxes. For example, according to federal law enforcement
officials, tobacco products sold at retail are purchased at a store in
a low-tax state for transportation and illegal resale in a state with
a higher excise tax.
Indian Country Sales:
Alternatively, state excise tax-free cigarettes can be purchased at
retail in Indian country for illegal resale to nontribal members in
other locations. Cigarettes sold to tribal members in Indian country
are exempt from state taxation but not sales to nontribal members,
unless state law or an agreement exempts sales to nontribal members
from taxation.
Domestic Internet Web sites:
Additionally, delivery sales of tobacco products, like Internet-based
sales, have been made without the proper payment of state excise taxes
by either the seller or the purchaser. Delivery sales occur when the
seller is not in the physical presence of the buyer when the purchase
is made (e.g., telephone, mail, or Internet services) or delivered.
However, according to the experts we interviewed, the Prevent All
Cigarette Trafficking Act of 2009 has limited illegal Internet sales of
tobacco products by requiring advance payment of state excise taxes
and prohibiting the delivery of tobacco products through the mail.
Relationship to supply chain: Retail;
Examples of illicit trade schemes:
* Purchasing tobacco products from retailer in one state for illegal
transportation and resale in another state;
* Purchasing cigarettes in Indian country for resale to nontribal
members;
* Purchasing cigarettes from domestic Internet Web sites without
appropriate payment of tax;
Taxes and fees avoided: Customs duty: N/A;
Taxes and fees avoided: Federal excise tax: Paid;
Taxes and fees avoided: State/local excise tax: [Check];
Taxes and fees avoided: MSA/escrow payment: [Check].
Source: GAO analysis.
Numerous illicit trade schemes involve tobacco products purchased at
retail. For example, a retail store on Stillaguamish tribal trust land
in Washington sold more than $55 million of contraband cigarettes
without the payment of state excise taxes. According to court
documents, more than $25 million in Washington state excise taxes were
avoided as a result. In another example, law enforcement officials
reported that individuals purchased tax-free cigarettes from retail
stores similar to the one seen in figure 22 for transportation and
illegal resale in New York City.
Figure 22: Tonawanda Retail Store Selling Tax-Free Cigarettes:
[Refer to PDF for image: photograph]
Source: ATF.
[End of figure]
Avoiding MSA Payments:
According to an official from the National Association of Attorneys
General, the evasion of MSA payments has been a significant problem
for states. Manufacturers that are party to the MSA, including
original participating manufacturers and subsequent participating
manufacturers, are required to make payments to MSA states that are
based on their total domestic sales. This official stated that
subsequent participating manufacturers have evaded MSA payments by
underreporting on their domestic sales.
Some domestic and international manufacturers are not party to the
MSA and are known as nonparticipating manufacturers. ATF officials
reported that the evasion of MSA escrow payments by nonparticipating
manufacturers is also an issue for state governments. MSA states have
created statutes requiring these manufacturers to make payments into
escrow accounts and these payments are based on sales into each MSA
state. According to an expert we spoke with, a typical MSA escrow
fraud scheme involves underreporting cigarettes sales into states. ATF
officials explained another common scheme involves falsely reporting
that cigarette sales are destined for a non-MSA state or Indian
country, when the sale is actually made in a MSA state.
Relationship to supply chain: Other;
Examples of illicit trade schemes:
* Underreporting cigarette sales to MSA states;
Taxes and fees avoided: Customs duty: N/A;
Taxes and fees avoided: Federal excise tax: Paid;
Taxes and fees avoided: State/local excise tax: Paid;
Taxes and fees avoided: MSA/escrow payment: [Check].
Source: GAO analysis.
Figure 23 shows a recent case in which a small cigarette
nonparticipating manufacturer based in North Carolina evaded MSA
escrow payments on cigarettes sold in Virginia, Kentucky, Tennessee,
South Carolina, and Georgia. According to court documents, they
falsely underreported its sales to these states in order to evade its
obligation to make escrow payments. In 2008, for example, they falsely
reported it sold 30,000 packs in Virginia in 2007, when in fact it had
sold more than 1.5 million packs. This resulted in the evasion of
approximately $580,000 in escrow payments owed to the state of
Virginia.
Figure 23: Example of MSA Escrow Payment Evasion:
[Refer to PDF for image: illustration]
Required Cigarette Sales Report for 2007 for Virginia:
Reported packs sold: 30,000 (2%);
Actual packs sold: 1,570,000 (98%).
Sources: GAO analysis and Nova Development (clip art).
[End of figure]
In another case, an importer in New York purchased cigarettes
manufactured by a foreign nonparticipating manufacturer. According to
court documents, approximately 1 million cartons of these cigarettes
were imported and then sold to a distributor in South Carolina. However,
only 250,000 cartons were sold and shipped directly to the South
Carolina distributor. The other 750,000 cartons were diverted through
wholesalers in Mississippi, a non-MSA state. The Mississippi
wholesalers then falsely reported that the cigarettes were sold in
Mississippi when the cigarettes were actually sold to the distributor
in South Carolina. The distributor in South Carolina only reported
sales of the 250,000 directly shipped cartons and evaded more than
$800,000 in MSA escrow payments and state excise taxes due to South
Carolina on the diverted 750,000 cartons.
[End of Appendix I]
Appendix II: GAO Contacts and Staff Acknowledgments:
GAO Contact:
Loren Yager (202) 512-4347, or yagerl@gao.gov:
Staff Acknowledgment:
In addition to the contact named above, Christine Broderick (Assistant
Director), Brent Corby, Barbara El Osta, Etana Finkler, Jeremy
Latimer, and Justine Lazaro made significant contributions to this
report. In addition, Pedro Almoguera, Karen Deans, Grace Lui, and
Alana Miller provided technical assistance.
[End of Appendix II]
Footnotes:
[1] Pub. L. No. 111-31, Div. A, 123 Stat. 1776 (2009).
[2] Pub. L. No. 111-31, § 3.
[3] Pub. L. No. 111-31, § 302(a).
[4] Pub. L. No. 111-31, § 302(c).
[End of section]
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