13.7 Evasion of taxes on tobacco products

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Evasion of taxes on tobacco products is a very large problem internationally, making substantially cheaper products available to consumers and reducing the effectiveness of tobacco taxes both as a source of government revenue and a means of reducing tobacco consumption. Analysis of data from the International Tobacco Control Policy Evaluation Study (ITCPES) shows that smokers who have access to untaxed cigarettes are less likely to make a quit attempt than those who only buy full-priced cigarettes.124

Evasion of taxes undermines the health impact of tobacco tax policies. Apart from making cheaper products available to those willing to buy from illicit sources, it exerts downward pressure on tobacco prices generally, thereby encouraging increased consumption. Such products often do not comply with health regulations, such as prohibitions on selling to minors, package warnings and other labelling requirements and could also evade any future restrictions on delivery of toxins.[56] In developing countries, smuggling of cigarettes makes top international brands available at affordable prices to image-conscious young people who regard such products as sophisticated and stylish. Evasion of tobacco taxes also reduces government revenue for tobacco control, other public health programs and other public sector programs and investment.

Evasion of tobacco taxes is a law-and-order as well as a health issue. In Australia research by the Australian Tax Office suggests that organisers in the illegal tobacco market are often actively involved in other forms of criminality such as drugs, money laundering, identity fraud, and car rebirthing.192 Internationally there is growing concern that proceeds from smuggling have been helping to finance terrorist groups.193-195 The growth of organised crime networks can increase the general level of corruption in a country, reducing barriers among citizens to the purchasing of other black market goods, and providing incentives to public officials to facilitate black market activities.194, 196, 197

This section describes three forms of evasion in Australia: bootlegging between Australian states and territories which was a major form of evasion in the 1980s and early 1990s; sale of untaxed, unprocessed tobacco (known as chop-chop), a form of evasion that emerged in the late 1990s when state fees were abolished and which remains a serious challenge for the Australian Tax Office; and smuggling of manufactured cigarettes, a huge problem internationally, and an emerging problem in Australia.

13.7.1 'Butt-legging' between Australian states and territories

The variability in licence fees evident in Table 13.4 in Section 13.2.2 above resulted in considerable differences between states in the retail cost of cigarettes. If the pre-fee value of a packet of cigarettes was $2.00, and the state business franchise fee in one state was 50%, then wholesalers would charge retailers $3.00. Retailers would add a further 20%[57] so that the recommended retail price would be $3.60. If the business franchise fee in another state was 100% then the wholesale price to retailers in that state would be $4.00, and the recommended retail price $4.80, a difference of $1.20 (33%) in the final price of cigarettes in the two states. Differences in legislation in each jurisdiction resulted in differences in definitions and treatment of stock transferred within companies, between states and licence holders. A variety of schemes emerged in the early 1990s that enabled tobacco sellers to minimise payment of fees, or to avoid paying them altogether.

According to an internal report produced by the National Crime Authority,198 these various schemes for bootlegging (or 'butt-legging' as it was dubbed in newspaper headlines at the time) included:

• failing to renew licences, thereby avoiding fees on stock sold in the previous month
• forging of documents to obtain a proportion of stock free of licence fees
• transferring of stock within companies to interstate warehouses, thereby avoiding fees in either the origin or destination states
• transporting of tobacco across several borders, allowing lawful sale to unlicensed wholesalers or to retailers who would dispose of products in undeclared sales
• purchasing of stock from jurisdictions with lower licence fees
• false representation of interstate sales
• non-disclosure of transactions involving unlicensed merchants.

The abolition of state business franchise fees brought these schemes to an abrupt end, however a new form of illicit trade very quickly emerged to fill the void.

13.7.2 The problem of chop-chop

With the end of the state business franchise fees, all excise duty in Australia was collected directly from manufacturers and so sources of cheap cigarettes evaporated. To meet the demand for cheap tobacco products, several operators began to distribute illegally grown or produced, un-branded, minimally processed tobacco known as 'chop-chop', suitable for use in roll-your-own cigarettes. Producers of chop-chop evade regulations on tobacco growing, processing and sales in order to avoid excise and GST.

The 2004 National Drug Household Survey found that 38% of all Australians aged 14 years and over were aware of chop-chop[58], and of the 8.8% of this group who had ever smoked it (about 3.3% of the total population), about 21.7% (0.4% of the total population) smoked it half the time or more. A telephone survey of NSW smokers late in 2004 reported in the Australian and New Zealand Journal of Public Health199 similarly found that about 3% of respondents always used chop-chop and that 2.6% used it occasionally. The study found that chop-chop smokers were more likely to be male, smoke more heavily and be less well educated.

In a report prepared for British American Tobacco Australasia in 2005, consulting company PricewaterhouseCoopers estimated that one in every 17 cigarettes smoked in Australia in 2004 was illegal. This amounted to between $300 million and $450 million in lost tax revenue.113, 200 A report published by the Australian National Audit Office in 2006 however put the estimated loss in excise revenue much lower, at about $98 million in 2004–05, but still a 56% increase in estimated losses since 2001–02.192 This estimate is much more consistent with the data from population surveys.

The Australian Taxation Office (ATO) has put considerable resources into pursuing growers and distributors of chop-chop. Extra investigators were appointed[59] and amendments to the Excise Act in 2000 tightened licensing and reporting requirements for growers, and instituted penalties of up to two years' imprisonment or financial penalties of up to $55,000 for some offences.201

Following an audit of excise collection in 2001, the Australian National Audit Office made a number of recommendations for further improving the administration of excise in the areas of 'supporting business systems, risk management and governance'.202 In 2004, further amendments to excise legislation203 were put in place that

• included tobacco seed and plant as well as leaf in provisions relating to movement and permissions for movement (Sections 44 and 117D) and
• enabled disposal of forfeited, seized goods and use of evidentiary certificates in prosecutions (sections 107FJ and 107GB).

The powers extended to ATO by these amendments enabled it to pursue further strategies to improve compliance including:

• measuring crops planted on licensed premises, ensuring correct bookkeeping procedures and identifying growers planting for the next season
• reviewing manufacturers' refunds, remissions and drawback processes and supervision of tobacco destructions and
• reviewing and reissuing excise storage licences and continuing permissions of duty-free stores. 204

The Australian Taxation Office's estimates of the quantities of tobacco grown and the quantities diverted to the illegal market are presented in Table 13.21. The table also includes records of the quantities seized by the ATO and other law enforcement agencies.

Between 2000–01 and 2004–05, ATO estimates of tobacco illegally diverted as a total tobacco grown increased from six to nine percent. During the 2002–03 and 2004–05 financial years, the seizures represented about 20% of the tobacco that the ATO estimates was illegally diverted.

Over the 18-month period to December 2004 there were 50 prosecutions, 30 of which resulted in custodial sentences and Penalty Infringement Notices issues to 26 retailers around Australia.200 The Australian Customs Service also devoted considerable resources to preventing illegal importation of unprocessed tobacco from overseas.[60]

In 2006 the Excise Laws Amendment (Fuel Tax Reform and Other Measures) Act205 removed proscribed reporting requirements for tobacco producers (Section 50), but widened the powers of the ATO to nominate persons who must account for tobacco leaf and pay excise duty in respect of leaf not accounted for and to specify for each person exactly the information required. This allowed the ATO to better tailor reporting requirements depending on the risk posed by each grower, distributor and manufacturer. Since this time, the Act has required three-yearly renewal of licences. When deciding whether to grant a licence, the ATO can now take into account the applicant's skills and experience (s.39A (2)(fa)). When deciding whether an applicant is a 'fit and proper person' to hold a licence it can take into account both 'the extent of the person's compliance, within four years before the application was made, with any law administered by the (Commissioner of Taxation).' (s.39B(ba) and 'the persons' financial resources' (s39B(ca))206

In its follow-up audit in 2006, The National Audit Office (ANAO) reported that the ATO had fully implemented its recommendations to

• articulate strategies and assess performance related to the Tobacco Industry Group Business Plan
• ensure compliance with legislation
• share intelligence with the Department of Health and Ageing and other agencies
• ensure that excise intelligence systems meet business needs
• share intelligence with retailers, the Australian Customs Service, the Australian Federal Police, and road transport authorities
• finalise a memorandum of understanding with the Customs Service and
• clarify the respective roles of the Tobacco Industry Group and Investigations Unit within the ATO.

The ANAO considered that the ATO had also substantially completed it plans to improve excise intelligence capacity, ensuring adequacy of staff skills.192

13.7.3 The emerging threat of contraband cigarettes

Each year throughout the world an estimated 400 billion cigarettes, or one-third of all legally exported cigarettes, end up illegally smuggled across international borders. (A total of about 5.5 trillion (5,500 billion) cigarettes were produced worldwide in 2004.)95, 207 Cigarettes are the world's most widely smuggled legal consumer product.208

Cigarettes may be smuggled in at least three ways: bootlegging by small-scale operators unlawfully moving stock from low- to higher-taxing jurisdictions; large-scale diversion of cigarettes in transit; and production and sale of counterfeit cigarettes.209

13.7.3.1 Bootlegging of cigarettes

Now that it has a single national system for taxation; being an island many thousands of kilometres from most other countries; and given that street sellers are not common — bootlegging of cigarettes is no longer thought to be a significant problem in Australia.

13.7.3.2 Large-scale diversion of cigarettes produced by licensed manufacturers

Much more of a problem internationally is the large-scale diversion of cigarettes onto the black market while products are in transit. This is able to occur because of lax systems for accounting for and checking of cigarettes exported to other countries and then sent on to further destinations. The existence of a large volume of duty-free tobacco products in international commerce creates opportunity for smuggling.

The extent of any diversion of cigarettes produced in Australia is unknown. In 2000–2001, Australia exported more than 1,800 metric tonnes of tobacco products including 8.5 metric tonnes to Australian territories and 942 metric tonnes to various South Pacific islands.210 In some cases, the amounts exported to particular countries seem very high compared with the population of those countries.211 Stock exported to distributors in particular countries could be being sold to retailers beyond that country.

13.7.3.3 Counterfeiting of cigarettes

In the first two forms of smuggling, national finance ministries lose revenue but tobacco companies sell the same amount of product and may benefit from increased demand among consumers. A third form of smuggling involves the production and tax-free distribution of counterfeit cigarettes. With counterfeiting, both governments and licensed tobacco companies lose revenue.

British American Tobacco Australia includes on its website the following description of counterfeit cigarettes and the problems they pose in Australia.

What is counterfeit cigarette product?

Counterfeit cigarettes are copies of legal Australian brands, clandestinely manufactured and sold. Counterfeit cigarettes are direct copies of legal cigarette brands, produced overseas then illegally imported into Australia and sold. The quality of counterfeit product varies, but some feature packaging that is almost indistinguishable from the genuine article. Many consumers are unaware that they have purchased a counterfeit product until they try it.

How is it identified?

In recent years, the appearance of counterfeit product has greatly improved. Whereas spelling mistakes, poor pigment colouration and a lack of health warnings once made counterfeit products instantly recognisable, today consumers are often unaware that they have purchased a copy until they try it.

Many of the counterfeit cigarettes currently on the market have packaging of such high quality that even representatives of the tobacco retail trade have trouble identifying the product.

The smoking quality of counterfeit cigarettes also appears to have improved. Several years ago, counterfeit product was often identified through quality complaints lodged with the Consumer Response Centre (CRC). However, counterfeiters have begun to use better quality raw materials, resulting in cigarettes that are less easily distinguishable to the consumer.

It appears that in some cases counterfeit product is falsely sold as legitimate products, at the same price as legitimate products. In other instances, illegal operators openly offer counterfeit product at a reduced price.

How is it made?

Many of the counterfeit cigarettes that make their way onto the Australian market are believed to originate overseas, where the machinery and packaging processes to produce these products have been available for some time. In the past 5 years, counterfeit manufacturers have engaged in research and product development to try to reproduce the flavour of products on the Australian market.

Illegal operations have acquired sophisticated tobacco manufacturing machinery to enable them to engage in the lucrative counterfeiting business. Many factories have made copies of this machinery, to further expand their operations. As some machines have production capacities of 2000 cigarettes per minute, the future ability of these manufacturers to flood the Australian market is clear.

Dependent upon the amount the distributor wishes to spend, the manufacturers have the ability to produce cheap, easily identifiable counterfeit products, or products of exceptional quality. Anecdotal evidence suggests they even use trained tobacco blenders to calculate the mix of the product, and professional graphic designers to produce the packaging.

Cigarette-making machines are sometimes literally underground, inside mountains, or built on ships in order to be mobile. Some look like bomb shelters, their entrances hidden and controlled by computers or protected by armed guards. Manufacture is well organised and highly sophisticated, resulting in massive production volumes. Although several containers of counterfeit cigarettes have been intercepted at Australian ports, it is probable that others pass through undetected.

Why is it illegal?

Counterfeiting infringes the World Trade Organisation (WTO) Agreement on Trade-Related Aspects of Intellectual Property, known as the 'TRIPs Agreement'. This commits members to observe basic standards on the registration of trademarks, and obliges them to take enforcing steps against infringement.

Persons selling counterfeit product avoid the payment of excise by falsifying the customs declaration on import documentation. Due to the cash nature of their business, black market operators also avoid paying the GST and personal income taxes on their earnings. Furthermore, counterfeit product does not comply with Australian production standards and regulatory requirements, such as the display of health warnings and tar and nicotine labelling.

The risk to operators involved in this trade is very high, as Customs have the right to examine all consignments entering the country.

British American Tobacco Australasia corporate website212

Most counterfeit cigarettes appear to be manufactured in Asia. Philip Morris in the United States claims that North Korea, one of the world's most isolated countries, has become a leading manufacturer of counterfeit cigarettes. In an interview with the Wall Street Journal, company sources claim that some of these counterfeiting operations are state-run.213 Many are owned or financed, they say, by Taiwanese and Chinese criminal groups which smuggle the cigarettes they produce around Asia as well as into the US and Europe. Cargoes are often shifted from freighters to other vessels at sea in international waters, to mask their origin. In other cases, cigarettes move via a series of small ports.214

13.7.3.4 Quantifying the value of illegal cigarette sales

Estimating the size of a country's contraband market is at best extremely difficult and at worst downright impossible. As explained by Guindon, Perucic and Boisclair, official tax statistics don't take into account the smuggling of goods, and survey data are questionable because respondents may not know about or may be unlikely to reveal consumption of illegal products. Great care should be taken with data originating from tobacco companies which have an incentive to exaggerate estimates of the volume of those forms of illicit consumption that impact on their sales (in Australia, chop-chop and counterfeit cigarettes) and to minimise estimates of diversion of stock they have supplied to wholesalers.

In a report prepared for the Committee on Government Reform for the US House of Representatives, the US General Accounting Office reported that smuggling was a growing problem.215 Investigations into cigarette smuggling have increased in both number and complexity. In 2003 the US Immigration and Customs Enforcement (ICE) concluded 103 and initiated a further 99 investigations into cigarette smuggling. In the same year the Bureau of Alcohol, Tobacco, Firearms and Explosives (ATF) concluded 76 and initiated a further 153 investigations. The total value of cigarettes seized by these agencies[61] increased from US$1.3 million in 1998 to more than US$50 million in 2003. Between the 2000 and 2003 financial years, the value of counterfeit cigarettes as a percentage of the total value of counterfeit items seized increased from 9% to 44%.

In 2002–03 the Australian Customs Service detected 47 million illegally imported cigarettes representing evasion of duty to the value of $22 million.216, 217

Table 13.22 provides an estimate published by Euromonitor International of the penetration of counterfeit and other contraband cigarettes in Australia. No information is provided about the source of this data for this estimate.

It would seem that sales of contraband cigarettes in Australia have increased since 1999, but still represent a comparatively small percentage of the total market.