Smoking Gun: Illicit trade of Tobacco in Canada
In March 2016, the Macdonald-Laurier Institute, a conservative policy think tank from Ottawa, released a new report on the illicit trade in tobacco products in Canada, entitled 'Smoking Gun: Strategic Containment of Contraband Tobacco and Cigarette Trafficking' in Canada.
Article originally published in Reconnaissance's Tax Stamp News™.
The report provides a detailed and gripping account on the continued challenge Canada is experiencing from illicit tobacco, which has proven to be stubbornly persistent. The report estimates Canada’s contraband market in tobacco and cigarettes to be now more than $1.3 billion, which rivals the size of the country’s illicit narcotics trade.
And while the illicit trade in tobacco products in Canada has hardly abated, it has shifted and manifested in new forms. Today, two major sources of contraband dominate the Canadian market: counterfeit and, most significantly, tobacco primarily produced on, and then smuggled through, Native American reservations in Ontario and Quebec.
But this was not always the face of illicit tobacco in Canada.
The long path from smuggling to unlicensed manufacturing
The illicit trade in Canada has always been driven by taxes. As the report notes, in the 1980s and 1990s, the rise in Canada’s domestic federal and provincial taxes, coupled with the lack of export taxes, created a substantial tax differential between Canada and the United States. This enabled large-scale ‘returning exports’ schemes with the cooperation of transnational cigarette companies (ie. product marked and designated for export that had left Canada tax-free and systematically returned to Canada without applicable taxes paid).
Native American involvement in the illicit trade at that time was limited to the utilization of Native Americans for their intimate knowledge of the intricate routes between the many islands in the St Lawrence River in Akwesasne, a Mohawk Nation reserve that straddles the river and the US-Canada border. Native American-led illicit manufacturing, however, appears to have been limited at that time, as transnational cigarette companies supplied ample genuine cigarettes for the illicit ‘returning export’ schemes.
These schemes were choked off through a concerted effort in the late 1990s through the increase of export tax, tax rollbacks to close the tax gap, as well as enforcement and legal actions against transnational companies. As a final measure in 2007, the Canada Revenue Agency mandated tobacco tax stamps on all cigarette packs and tobacco tins manufactured or imported into Canada.
While these comprehensive efforts have put an end to the returning export schemes of the 1990s and virtually eliminated the trafficking of genuine branded cigarettes, it has hardly put an end to the illicit tobacco trade in Canada.
The demand for cheap tobacco products and cigarettes, driven by the high price of legitimate cigarettes with an average retail price of about $100-$125 per carton, has found new sources of cheap untaxed and under-taxed tobacco products.
According to the report, today the overall share of illicit tobacco in Canada is estimated at 17.9% by GfK, with main concentrations in Quebec and Ontario, where illicit tobacco makes up almost a third of the market.
To fulfil this unsatisfied demand for cheap tobacco, since the turn of the millennium Canada has experienced a continuous increase in illicit manufacturing, wholesale and retail operations on reservation land along the St Lawrence River with various degrees of legal compliance. The Royal Canadian Mounted Police has identified four major manufacturing or distribution hubs of untaxed tobacco: Akwesasne near Cornwall, Ontario; Kahnawake near Montreal, Quebec; Tyendinaga near Belleville, Ontario; and Ohsweken (Six Nations) near Brantford, Ontario.
These illegal manufacturing and distribution hubs churn out cheap untaxed and under-taxed tobacco products in the form of unlicensed, unregulated and sometimes unbranded products, including the notorious ‘baggies’ (200 cigarettes in unbranded plastic bags) which sell for $20-40 per bag.
Various jurisdictional issues, lack of enforcement resources, legislative gaps and, most importantly, the apparent lack of an appropriate, comprehensive and coordinated strategy designed to meet this new illicit trade threat have hampered enforcement efforts against these activities.
Today’s illicit trade landscape in Canada requires a completely different strategy. Existing anti-illicit tobacco efforts driven by the activities of the 1990s concentrated on controlling the legitimate distribution chain of major transnational tobacco manufacturers to eliminate the then prevalent diversion of major branded tobacco products through export and diversion schemes. Today’s illicit trade, however, exists almost exclusively outside the legitimate distribution chain, rendering current strategies ineffective, even futile.
For example, Grand River Enterprises (GRE), the principal producer for the Six Nations reserve, is federally licensed and therefore has unfettered access to the Canadian tobacco leaf market, including cut-rag (tobacco that has been cut into fine strips for use in cigarettes) and other raw material inputs. As a result GRE is able to produce high-quality contraband products on Canadian soil.
Similarly, illegal manufacturing sites in Akwesasne and Kahnawake source their raw materials from a plethora of legal and non-legal sources. Many of these facilities are not registered with federal and provincial authorities and therefore have limited access to cut-rag and other raw materials.
To circumvent these restrictions these production facilities source cut-rag tobacco from their operations on the US side, who have easy access to US cut-rag. The US-based Akwesasne manufacturing facility then ships finished product to its Canadian counterpart for final distribution.
From these manufacturing facilities, the products are then transported by organised criminal organisations, including the Mafia and the Hells Angels, across Canada into unlicensed retail outlets, tobacco outlets on native reservations and smoke shacks. These products never enter the legitimate distribution chain and are not impacted by licensing, reporting or tax stamping requirements.
Solutions to meet the threat
The MacDonald-Laurier Institute report provides a suite of policy recommendations to meet this new threat profile. The policy suite takes a comprehensive approach to tackle the issue through various provisions, including taxation equalisation, revenue sharing with First Nation tribes, increased enforcement and public awareness campaigns.
Most notably, the Institute recommends controlling the movement of raw materials, including tobacco and other direct materials. Cigarettes are relatively simple products to manufacture, requiring only a handful of inputs or raw materials, including tobacco, acetate tow (industry-standard filters) and cigarette paper. These materials are quite unique to tobacco products, with few uses outside of the tobacco industry. Without these three direct materials, no illegal tobacco products can be manufactured.
The report discusses the consideration for these raw materials to fall under tighter licensing, reporting and tracking requirements. The report is not the first to raise these issues – they were debated passionately during negotiation for the FCTC Protocol to Eliminate Illicit Trade in Tobacco Products.
While consensus could not be reached at that time, the FCTC recommended the issue of licensing and direct material restrictions be revisited within three years of ratification. Concerns at the time included the potential availability of viable substitutes for illicit actors and the impact on other industries that use these direct materials in legitimate non-tobacco related products, for example automotive filtration.
Besides the deferment of action on these issues in the FCTC, Interpol and the World Customs Organization have started to focus on the control, tracking and enforcement of these components.
Elaborating on the Institute’s considerations on the issue and given the unsettled debate on the topic, it is this author’s opinion that these issues should be revisited.
Tobacco growers in Canada and the United States, as well as importers of tobacco, should be subject to stringent licensing requirements. Once licensed, growers and importers should be required to identify the source and the final destination of raw leaf and track raw leaf tobacco bales – also referred to as hogsheads – until the tobacco reaches licensed manufacturing facilities.
Stringent reporting requirements should underpin such a tracking regime to ensure raw tobacco leaf used in tobacco manufacturing can be traced back to its point of origin.
Similar regulations should apply to acetate tow and cigarette paper. There are only a few manufacturers globally for these raw materials, which – as said before – have limited commercial use outside of the tobacco industry, and a comprehensive track and trace regime would ensure continued direct material access for legitimate non-tobacco uses.
The manufacturers, importers and distributors of these raw materials should be subject to similarly stringent licensing, reporting, as well as tracking and tracing requirements. These raw materials should be tracked from point of raw materials manufacture until they reach licensed manufacturing facilities, to avoid diversion and unlicensed production. Detailed reporting requirements on the raw materials shipments would aid tax authorities greatly in production enforcement.
Finally, a comprehensive system of civil, monetary and criminal fines and penalties should underpin such a licensing, reporting and tracking system to aid enforcement and act as a deterrent.Canada’s illicit trade threat has morphed significantly over the last two decades, moving from diversion of genuine branded products to unlicensed products. Canada’s enforcement regime has to adapt to meet this evolving threat.
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