Illicit Tobacco: What's the Big Deal? (part 1)

Dec 15, 2012

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The illicit trade of tobacco is a global multi-billion dollar criminal market that some believe is fueled by the good intentions of health groups that advocate measures such as higher taxes and plain packaging. While big tobacco frets over the increasingly regulated industry, criminals frolic over the demand for cheaper smokes. This is Part One of a three-part series examining the different macro environmental factors of the illicit tobacco market and its related analyses. First, we focus on how, from a global perspective, this illicit trade is positioned and managed. In subsequent editions, Parts Two and Three will look specifically at the Canadian context and examine possible courses of action.

In most parts of the world, the sale and consumption of tobacco to adults is allowed with varying legal limitations, regulatory oversight and other considerations that include the collection of tax and duty. The legitimate tobacco industry operates within this highly ­prescribed framework and is able to generate impressive returns. It should come as no surprise then, that this active, albeit controversial, market is prime ground for those select few who view tax evasion as an opportunity. Some working outside these highly politicized tobacco laws, do so with entrepreneurial vigor.

Tobacco tax fraud in Sweden earns lucrative profits for criminals and deprives the economy of millions in tobacco tax. One news report states that, between 2009-2011, twelve cigarette import companies robbed the state of €64 million (US$81.3 million) in tobacco taxes. One of these incidents alone comprises $20.3 million USD in lost taxes. The tax fraud scheme involves the legal import of cigarettes and then quickly selling the them at lower prices before the required time limit (72 days) to declare the importation to tax authorities. By the time authorities discover the fraud, the registered owners have declared bankruptcy and are on the run. Instructions for this type of scheme were reportedly posted on the Internet. While searching the car of a man convicted for ­economic crimes and links to organized crime in 2005, Swedish authorities came across a how-to plan which explained the tobacco tax scheme.

Source: hetq online (June 21, 2012), “Tobacco Scheme Robs State of Millions”.

As with most criminal enterprises, those engaged in illicit trade operate to make a profit. Tax evasion schemes are typically multi-dimensional and offer opportunities at different stages of the manufacturing and distribution process. Substantial profit can be made, based on varying degrees of innovation and the margin upon which it is possible to undersell a legitimate competitor – and that is where each country’s laws affect levels of criminal interest.

Illicit tobacco trade is influenced by the price differential between taxed and untaxed cigarettes, which varies from country to country. Domestic regulations and legislation also differ in forms of severity.

Both tax evasion potential, and the ease with which rules can be circumvented, have an impact on the regional dynamics of the illicit trade. This is not to exclude other influencers, such as economic conditions, geographical location, psychographics and demographics.

The modest penalties associated with the illicit trade in tobacco is another important factor fueling this particular market.

Attach low risk to substantial profits and the result is a shrewd cast of characters drawn to a very dynamic criminal market.

In addition to low risk and high profits, other commonalities define the illicit trade of tobacco in many countries. One of the more obvious, relates to supply and demand – quite simply, there is a willing consumer market for contraband.

Tobacco may be considered a ‘filthy’ habit for many people, but smoking a ­cigarette is practicable and legal (with the exception of Bhutan where smoking has been banned since 2004). It’s safe to say that for many otherwise law-abiding ­citizens, the only real difference between contraband and lawful tobacco is price.

The World Health Organization and other mainstream reports suggest that the illicit trade in tobacco is particularly attractive to those who are price sensitive. Young people or those in lower-income brackets are prime targets for the black market.

An interesting sociological examination of the contraband market took place in 2003 in a disadvantaged neighbourhood in Harlem, New York, where the respondents “tended to be poorer and less educated than the general Harlem population.” In the study, illicit tobacco vendors “were uniformly viewed as a justifiable and appreciated response to the high price of cigarettes.” Study participants commented: “we’re thankful for the $5 man,” or “it’s stressful living in Harlem, especially with the economy now. You can find a pack of cigarettes before you can find a job.” One might be inclined to cynically call for an end to poverty or unemployment before entertaining the complexities of eliminating a market for contraband.

A prominent headline in recent months relates to Maryland Comptroller Peter Franchot’s stance on illegal cigarette activity. Earlier in the year, he urged the Maryland Senate to pass legislation to increase the penalties for tobacco violations associated with the smuggling of cigarettes and other tobacco products into Maryland. The House of Delegates passed the bill by a 115 to 12 vote margin, however the Senate did not follow suit. Maryland’s cigarette seizures have quadrupled between 2010 and 2012. The penalties in Maryland are so minor that one couple was arrested three times in three months, all on charges of transporting contraband.

Source: The Baltimore Sun, “Cigarette seizures quadrupled over two years” (July 25, 2012).

Some consumers, and even some non-consumers of tobacco, view the issue of contraband cigarettes as relatively harmless or not as serious as other criminal activity. The import and sale of occasional cartons is routinely practiced by otherwise lawful citizens. For example, Finnish Customs estimates that 100 to 200 million duty-free cigarettes are legally carried into Finland across the border from Russia each year. A resident of Finland is allowed to bring back one carton of cigarettes from Russia, where it can cost as little as one-tenth of the Finnish price. This occasional allowance can be interpreted by some to mean two cartons per week. Career smugglers have been known to undertake ­”soldier-ant smuggling”, where busloads of Finnish people returning from sojourns to Russia are solicited to each bring a carton of cigarettes across the border. The tax loss to Finland is formidable, yet this illegal practice is considered harmless by most people.

Looking at the size of the contraband market, it is evident that this laissez-faire attitude extends across numerous borders. In an agreement between the European Commission and Philip Morris International (PMI), a study was conducted to assess the illicit trade in contraband and counterfeit cigarettes in the European Union (EU). The study, by audit firm KPMG, estimates that one in ten cigarettes sold in the 27-nation bloc in 2011 was contraband. The report shows a steady climb for black market cigarettes over a five-year period. It is worth mentioning that, while the study was funded from an industry source, the European Commission considered the data to be of sufficient quality that the results have been shared with member states and the European Anti-Fraud Office (OLAF).

Cost savings, while key, is not the only factor driving the purchase of illicit product. Studies indicate that easy access fuels demand for the contraband market. Setting aside price, youth are unable to lawfully purchase cigarettes – they “provide a demand for contraband cigarettes that is independent of tax issues.”

Ultimately, one cannot dismiss the fact that there is a willing market for illegal ­cigarettes – with few hurdles in the way. Erroneously believing that the purchase of illicit tobacco products is a somewhat ­victimless crime, many otherwise law-abiding people knowingly become black market consumers in order to benefit from cheaper contraband products.

The clandestine nature of the illicit trade in tobacco poses the obvious challenge of accurately measuring the scope and extent of the problem. In some authoritative reports, contraband tobacco is cited as less lucrative than narcotics. In other more anecdotal accounts, the very opposite is suggested. A Virginia State Crime Commission staff report on illegal cigarette trafficking quoted one agent with the Virginia State Police as saying that “illegally trafficked cigarettes now have a higher profit margin than cocaine, heroin, marijuana, or guns.”

Whether it is less or more lucrative than narcotics, news reports attest to the potent purchasing power of contraband. In 2009, the Wall Street Journal reported that an exchange of one kilogram of cocaine took place for 3,000 cartons of cigarettes. In another incident, according to the U.S. Attorney’s Office, a Virginia man was sentenced in 2010 to more than 18 years in prison for conspiring to hire a hit man to murder someone he believed had stolen more than 15,000 cartons of his contraband cigarettes. The case was part of an investigation that charged more than 14 people for their role in the purchase/trade of $8 million in drugs and nearly 40 firearms for 388,000 cartons of contraband cigarettes to sell in New York. The U.S. Bureau of Alcohol, Tobacco, Firearms, and Explosives (ATF) estimates that a cigarette trafficker taking cigarettes from Virginia to New York City can make about $4 million for a single truckload of 800 cases (one case is usually equivalent to 50 cartons of cigarettes).

A joint report issued by Her Majesty’s Revenue and Customs (HMRC) and the UK Border Agency in April 2011 explains that illicit whites, including Raquel and Jin Ling, have now established themselves in the UK. “Along with counterfeits, they represent the most significant threat to legitimate trade and tobacco revenues in the UK from large scale organized criminality,” it states. Illicit whites, also known as ‘cheap whites’, are made specifically for smuggling and involve the legal production of low-cost cigarettes with made-up brand names. Unlike counterfeit, some of the ­cigarettes bear a similarity to popular brand products but they do not infringe intellectual property rights. The cigarettes are sold legally to a purchaser in the country of origin and subsequent purchasers then smuggle the product across borders without payment of tax. The product is the sold at half the price of domestic duty-paid cigarettes.

Source: “Tackling Tobacco Smuggling – building on our success. A renewed strategy for HM Revenue & Customs and the UK Border Agency” (April 2011).

Funding Criminal Activity
Of particular concern is how smuggling profits are invested in other criminal activities. A senior official who heads the cigarette smuggling unit at the European Union’s Anti-Fraud Office (OLAF), reportedly complained that “this trade is financing organizations that are involved in other activities including drug smuggling.”

At the Bolivia-Paraguay border, organized crime and smuggling operations are known to use contraband to launder their money. A centre that provides research, analysis and investigations on organized crime in Latin America states that “while the sale of contraband seems like a lesser crime compared to cocaine trafficking, it is not so far removed from it. Contraband is actually quite commonly used by criminal structures to launder profits from other criminal activities. The lack of recorded transactions provides groups with an easy way to invest the bulk cash associated with drug profits, and allows them to diversify their income as well.” Like many lawful companies, transactions conducted by organized crime groups employ sound practices that enhance their legitimate and/or illegitimate business prospects.

Disturbingly, evidence also suggests the illicit trade in tobacco finances groups that pose a threat to national security. Operation Smokescreen, which took place between 1995 and 2000, revealed that a Hezbollah cell operating in the United States was ­generating money through illegal cigarette trafficking, primarily from North Carolina to Michigan. The money was allegedly used to sponsor military training overseas. Some sources say that over $8 million dollars was illegally earned. The reach of the threat and harm posed by these and other organized crime activities is difficult to appreciate fully and perhaps even record accurately.

The profits from the illicit trade of tobacco are substantial enough to earn the attention of criminals at varying levels of skill and sophistication. Organized crime is resourceful and capable of innovative tax evasion schemes that rob the global economy of billions of dollars every year and put public health and safety at risk.

Opinions on the price of tobacco often depend on objectives. For many health advocates, controlling the price of cigarettes through taxation assists in reducing tobacco consumption. Governments benefit from its additional revenue. Those who oppose higher taxes include smokers and the tobacco industry, for obvious reasons. Reducing the illegal supply of cheaper products and associated criminal activity is perhaps the more compelling objective for those opposed to increasing or maintaining higher taxation rates. One thing is certain, this is a highly politicized debate.

Interstate 95 is being used to take cigarettes from low-tax states like Virginia and North Carolina to high-tax states like New York. The justice department estimates these states are losing $5 billion every year on untaxed cigarettes. ATF special agent in Northern ­Virginia explains that the venture is profitable, hard to detect and tempting to criminals because they face less jail time if caught. One Virginia man was trading millions in cash, cocaine, heroin, even luxury automobiles for untaxed cigarettes.

Source: WWT NBC12, “Cigarette Smuggling” (July 11, 2012),

It is not likely that policy decisions will reconcile all these varying and contrasting points of view. For example, the World Bank takes a strong position on the economics of tobacco. Its website explains that “even where smuggling becomes a serious problem, tax increases bring greater ­revenues and reduce smoking.” Some within law enforcement might argue that the cursory reference to smuggling being a lesser consideration does not delve deeply enough into the real implications and unintended consequences of the illicit trade of tobacco. Nations struggling with debt and financial crisis might agree to conditions required for assistance from the World Bank or willingly embark on policies to generate much needed revenue to avoid bankruptcy or a recession.

Regulations guiding tobacco taxation schemes cannot help but vary at the global, regional, national, and inter-domestic levels. The resulting imbalance creates opportunities in the market place for tax evasion and provides unintended fodder for criminal groups.

One solution being currently proposed in Europe, is to implement a single, high EU-wide cigarette tax. It is an approach that strives to tackle price disparity within an entire region. EU member states have a veto on tax policy, however, the initiative seeks a new minimum cigarette tax rate starting in 2014. Countries where the tax is lowest, like Bulgaria, Greece, and Romania, would have until 2018 to implement the change.

Even if this could be accomplished within Europe, it is not too difficult to forecast that smugglers will forge other routes to ensure continued activity in the European black market. This is already evidenced by the amount of illicit or ‘cheap whites’ that are currently being smuggled into the 27-nation bloc by transit zones along the eastern EU borders.

While the proposed EU-wide cigarette tax initiative does not completely eliminate the illicit trade of tobacco, it approaches policy change in a coordinated fashion that can serve to undermine opportunities and levels of unlawful profit.

Reducing the pull and prospects of illicit tobacco appears to be a workable, albeit imperfect, solution. One unavoidable focus is price. Higher taxes have proven effective in reducing smoking rates but also in increasing contraband tobacco. The decision must ultimately consider whether the illicit trade of tobacco, and its unintended consequences, surpasses smoking rates as a priority. If so, minimizing the illicit profit margin, or in some way increasing the cost of illicit production, must become a priority. Other equally important measures include increasing penalties associated with the illegal supply of tobacco, setting up obstacles to access, promoting awareness about the wider impacts of contraband, and increasing enforcement pressure. These synchronized steps may not eliminate the problem, but can take some of the wind out of its sails.

The prohibition on alcohol in the United States began in 1920 and ended with a constitutional amendment 14 years later in favor of regulating alcohol rather than banning it. Despite this historical experiment, a number of health advocates and other interest groups believe that a gradual banning of cigarettes along with other controls will eventually work towards curbing and eventually eliminating tobacco consumption.

Some countries have already proposed legislation that moves towards a de facto prohibition of tobacco. Finland has a bill that calls for it to become smoke‐free by 2040. In Iceland, there is a proposal to prohibit cigarette sales except in pharmacies, and eventually for sales to be accompanied by a doctor’s prescription.

While prohibition as a result of regulatory suppression is a phased-in approach, it may fail to meet its goals, especially facing an existing demand for the banned goods.

Within the context of the World Health Organization Framework ­Convention on Tobacco Control (WHO FCTC), an agreement was reached on a protocol to eliminate illicit trade in tobacco products. After four years of negotiations, the Intergovernmental Negotiating Body on a Protocol on Illicit Trade agreed on a draft text that sets the rules for combating the illicit trade of tobacco products. It will be submitted to the Conference of the Parties for consideration and adoption in November 2012. The draft looks specifically at control of the supply chain. It also establishes what constitutes unlawful conduct and sets out related enforce­ment and international ­cooperation measures. Under the protocol, the Parties propose to establish a global tracking system for tobacco products and reach agreement on other measures, such as licensing, liability, enforcement, information sharing and mutual legal assistance. The measures are designed to counteract and eventually eliminate the illicit trade in tobacco products. All Parties to the WHO FCTC, of which Canada is a member, are expected to monitor and provide periodic reports relating to their respective progress in combating the illicit trade in tobacco products.

Another recent development took place when Australia’s highest court upheld a law that prohibits tobacco companies from displaying their logos on cigarette packs. Starting in December, all regulated packs of cigarettes in Australia will only be allowed to feature graphic health warnings. Other countries are already looking at this unprecedented legislation for their own tobacco control strategies. Critics of this tactic quite legitimately speculate that the move will only impact the legitimate and regulated market while enhancing potentials for organized crime. They argue that plain packaging will make counterfeiters’ and smugglers’ jobs easier and make Australia an attractive target market for those who make and sell counterfeit products.

Bhutan, a South Asian country, enacted a total ban on tobacco sales in 2004. One report indicates that the black market has moved in to meet the existing demand. It adds that de facto (what happens in practice) or de jure (what the law says) prohibitions fuel illegal trafficking, not in spite of, but because of the ban.

Like other countries, the illicit trade of tobacco in Canada thrives, in large part, due to a price disparity between the legitimate industry and the fluctuating rate offered by the criminal market. What makes the situation in Canada unique with respect to the manufacturing of cigarettes, is the status of sovereign tribal territories.

Another factor adding to the problem of illicit trade relates to recent developments in the regulation of raw leaf tobacco. Ontario’s Ministry of Finance (which assumed oversight of all forms of raw leaf tobacco in the province on October 1, 2012) announced that anyone who grows, processes, sells, buys, imports, exports, or interjurisdictionally transports any varieties of raw leaf tobacco will be required to hold a registration certificate – but not until March 2013. This generous “grace period” provides a savoury opportunity for unlawful conduct and, in many ways, weakens law enforcement efforts to contain the illicit trade of tobacco.

The next article in this three-part series on the illicit trade of tobacco will focus on these challenges and provide some insight on how the matter of contraband is positioned within the Canadian context.

© FrontLine Security 2012