RESTRICTED
INDIRECT TAXATION OF
TOBACCO PRODUCTS
KEY AREA PAPER
Nbrc-'995
Ill.;
ON
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BATCo document for Province of British Columbia 23
April 1999


CONTENTS
AREA :',INDIRF.CT TAXATIQN'OFT(OBAC,C0
PRODUC71~S,,j
A. THE ISSUE
B. POLICY
C. STRATEGIES
D. DEVELOPMENT OF STRATEGIES
Company responsibility
Structure of excise taxadon and import tariffs
Level of taxation
Excise collection
ReJations with Government and its advisors
Industry relations
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BATCo document for Province of BritiSh Columbia 23
April 1999


KRY AREA! -: INDIRIPCT TAXATION OF TOBACCO
PRODUCTS
General Managers should refer to the Tobacco
Taxation Guide (dated December
1994) for a general background and detail on
indirect tax and trade issues. This Key
Area Paper concentrates on the development of
strategies to be adopted by operating
companies.
A. THE ISSUE
Tobacco indirect taxation (excise tax, sales tax,
VAT and import tariffs) is
the most sigruficant e!ernen: of the recail
selling price of tobacco products and
hence plays a major role in determining the
commercial environment in
which we operate. In particular, indirect taxation
determines the level of
retail prices. the price structure and therefore
the overall pattern of smoker
demand for our products. It is also closely linked
to, and significantly
influences the level of profitability and cash
flow performance of an
operating company.
Excise taxanon and VAT has always been a key
issue, but is becoming even
more so because of Government increases in the
level, with resultant higher
real prices, either for revenue or health reasons.
Also, competition,
particularly PNI, increasingly seek to influence
the structure of the taxation
system in order to optimise their competitor
position in the market place.
The criticai product category is cigarectes, which
accounts for well over 90%
of ,lobal tobacco consumption, this paper
therefore focuses upon cigarettes,
al;ough there is some reference to other tobacco
products.
International co-operation and cross fertilisation
between Governments is
increasing with regard to indirect taxation, as a
result of which both taxation
levels and structures are being shaped by external
influences.
Tobacco indirect taxation is therefor.- an issue
for General Managers who
should advise Nlillbank of all changes in tax
structures and levels, and discuss
any proposals for change with Millbank prior to
their submission to
Government.
B. POLICY
To manage the cigarette indirect taxation issue in
order to establish the most
appropriate re:aii price structure, whilst
optimising profitability and cash flow
over the Ion.- term.
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C. STRATEGIa
This policy will be achieved by focusing upon the
following main strategies
1. To define the management responsibility for
tobacco indirect =ation
within your company both from the public affairs
and commercial
viewpoints.
2. To establish a structure or system of import
duty and/or excise
axation most appropriate to the current and future
BAT brand mix,
securing maximum freedom to determine selling
prices without
Government intervention or approval, whilsE also
minimising the
ability of the retaii trade to vary prices from
those recommended by,
or fixed by !he manufac:urer.
3. To seek o reduce he ;ncidence of indirect
taxation, or to ensure that
its level does not increase at a rate ~,reater
than inflation. To seek to
ensure that ihe applicadon of Value Added Tax to
tobacco products
does not inc.---i5e the total tax burden.
4. To establish the mosi ef"ective method of
collecting the excise which
- maximises any -xc-.se credit terms.
maximises the involvement of the manufacturer in
the collecrion of
excise and minimises -he involvement of the
distributive and retail
trades.
facilitates the establishment of firm retait
prices.
minimises the ability of competitors to underpay
their import duty
and/or excise tax and so de-ive a competitor
advantage.
5. To main=n a diallogue and close working
relationship with key
Government of5cWs and Ministers and their advisors
in order to
influence their Indir= axarion policy.
6. To lead, but act (where appropriate) with, the
rest of the tobacco
industry and to maximise the benefits from
including other interested
parties such as farm ers. processors, suppliers
and the trade.
These strategies are explained in greater detail
in the subsequent sections.
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BATCo document for Province of BritiSh Columbia 23
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D. DEVELOPrvMNT OF STRATEGIES
1. Company Responsibility
Indirect tobacco taxation and pricing are general
management issues
and in addition will always involve different
business functions within
operating companies. It is essential to have c!ear
responsibilities for
the management of them.
The key elements are
strate-
gic planning of excise tax systems and pricing
accountina and computation or options
management of .payment and administration
lobbvina and Govemment 7,-iatiOnS
Millbank (Tobacco Taxat:on Department) is building
exper-ase and
contacts and a central daiabase o., ir.:or-macion
order to assist
operating companies. However, the responsibility
of managing local
excise issues is primarily that of the ope-a6ng
company and
particularly the General Managtr. Based on
expenence t.rorn around
the Group and outside. lobbying arguments are
being developed in
Nfillbank and will be circulated to operating
companies as appropriate.
Operabrig company management should keep Millbank
advised of
developments on indirec: :ax matters ar:~' seek
advice whenever
necessary.
2. Structure of excise taxation and import tariffs
The structure of any excise system determines the
pricing scenario of
the market place and has a signi5cant ;mpact upon
the level of
profitability. Both Mark-a-ing aid Finance should
fully understand the
implications of the current excise st-,jc:ure and
establish whether a
competitor advantage might acc--ue from a change
to a different
structure. In manv instancts. :~an2e -nay be
-ither inappropriate or
impossible while in other instan~z!s change may be
appropriate and
possible.
There is no single excise sirucw~e appropriate to
BAT on a global
basis because the competitor and brand mix
situations vary widely.
Companies should evaluate their own position and
future plans in the
market place, in order to determine the structure
most appropriate for
them. In most instances, long te-m profit
optimisation will normally
result from a totally or predominantly specific
excise taxation
structure, in preference to an ad valorem one. The
Optimum balance
between specific and ad valorem will depend upon
the brand mix of
each company. C
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In a high inflation environment an advalorem
structure is Likely to be
favoured bv Government, otherwise the relative
simplicity of a
specific srructure is appealing. Another
significant decision
influencing, factor 'is the narrower price ran-e
in a specific
environment. The structure is also highly relevant
to the key issue of
product quality with specific excise normally
resulting in higher
product quality than ad valorem because the latter
encourages once
competition and hence cost and quality reduction.
Import Lariffs are still an important element in
indirect taxation, but
the trend internaEonally is rapidly moving towards
a reducdon of
tani.ffs and ocher barriers to ree trade. To re!y
on such tax barriers to
.promcz' an uncompetitive business would not be
viable ~n the longer
term.
In th-2 txpanding global scenario whereby expors
zi.in-ently account
for over 201. of BATCo ciaarette sales, tarirfs
ar,, an imDortant
indirect tax and commercial issue. Since most of
our expor-4 are of
higher quality, higher pr-.c.- international
brands. our policy n export
marke,s is as follows:
eliminate tariffs
re-ilace ad valorem tarif-ts with specific tariffs
persuade Government to raise revenue chrouE~
excise and other
indirect taxation not tariffs
lobby for specific or predominantly specciEc
excise taxation,
because ad valorem excise multiplies the amount of
the tariff (a
tax on a tax).
It should also be pointed out that our policy on
tanffs in domestic
markets is -
generally the opposite of the above. In markets
where
BAT has a dominant share, or where competition is
limited because
restr-c-ed access to the market keeps out impons.
out policy is to
persuade GovemmenE to rninimise imports rh70Ugh
the application of
high :ariffs and other obstacles such as
pre-payment or early payment
of excise =es. (However, as noted above this is
becoming more
difficult.) Governments will be under increasing
international
pressure to equalise the exciseNAT structures and
rates applicable to
both imports and domestic productive Protection
for domestic
manufacture should therefore most appropriately be
sought t1irough a
.reasonabic' import tariff.
The structure of taxation for products other than
cigarettes generally
follows one of the above options. In the main,
cigars and cigarettes
do not directly compete agai.nst each other with
the possible exception Url
of miniature cigars. Similarly, Pipe tobaccos.
Chewing Tobaccos and C:
Snuff do not compete directly against cigarettes.
However Roll Your r1Q
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Own smoking tobacco is in direct competition with
manufactured
cigarettes. Companies must understand the relative
excise incidence
of these two product categories and their impact
upon relative price
levels and switching between the two categories.
Although
circumstances vary, the BAT policy is to minimise
the price advantage
of RYO and so maximise the market opportunities
for manufactured
cigarettes.
Government influence over retail prices varies
from completeiv
conErollin- them, to allowin,, 'ull freedom to
manufacturers. Retail
prices vary from being fixed by law or pr-act-,c--
to being free,'with the
manufacturers and the trade being able to change
prices by whatever
arrounc :hey wish. whenever they wish.
Because zircumstances vari widely, it is
diffi-cult to have a global
strate-v. However, the interests of the Group are
best served by a
siruation where ht company is free to deter-nine
the retail price tor its
brands which should then be Fixed, with the trade
margin being Linked
to this either as a fixed amount or a percemage (a
fixed amount is
preferabic). Although it is normally difficult to
dictate the degree of
involvement of Gove-nment in the ecise price
process. orit should
seek to eliminate or minimise :he involvement of
:he trade so that the
balance of power stays with the manufacturers.
In markets where stick sales predominate, clearly
the trade plays a key
role, but companies should examine every
opportunity to ma:arruse
the onces accruing to the manufacturer when excise
increases are
passed on to the consumer, although balancing this
with the need to
give the trade a satisfac:ory level of return
based upon the actual stick
price.
'Khei permitted, it is normally preferable for the
industry to apply for
and implement price increases collectively and
simultaneously and to
negotiate with Government, where necessary, on an
industry basis.
The psychology of smoker demand is such that hey
are more likely to
absorb smaller and more frequent price increases
than lar,,L- and less
frequent price inc-eases. During negotiaiions wi:h
Government
therefore it is preferable to seek the former
excise environment.
However. this has also to be interpreted in the
context of the general
level of inflation in the country plus the
significance of stick sales and
coinaze availability which may act as a constraint
to the
implementation of this strategy-
In markets of high inflation, it is always
preferable to take
manufacturers prices increases ahead of inflation
instead of behind it,
with the exact timing sometimes determining the
difference between LM
operating profitab;'icy or a loss. The ciming of
manufacturer price
increases however. sometimes has to be inte2rated
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BATCo document for Province of BritiSh Columbia 23
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increases, and it is desirable that this should be
so under certain
circumstances, although flexibility not to do so
should also exist.
It is frequently argued by the anti-smoking lobby
that the price of
tobacco products should be removed ~rrom the index
of retail prices of
the cost of living index. This would hen enable
Government to
impose hi,,hel levels of excise for 'health'
reasons, without impacting
negadvely upon the level of inflation. The effect
of excise increases
wi 11 be felt in any economy, whether or not they
are included in an
index of retail prices. To pretend otherwise is
naive while to -exclude
a bona fide product from sucn an index would give
rise to doubts
about :he validiry of Government stausrics
generally. Such an action
would limit the use o,' the index in --.onomic
policy formulation and
economic planning generally because :he use of an
incorrect statistic
wi;~ always have a distorting cff-=.
Companies shou'd oppose any such ai:empt. and seek
zo enlist the
support of trade unions who utilise the index for
wage negotiations,
cogethe7 with economists and stansuc-lans
sympathetic to the position
of 'Lhe :ndustry. Although this is :.he general
global strategy, there
may be c;rcumstanc,!s when the !evel of inflation
combined with price
controls may necessitate its 7emoval if to do so
is the oniv means of
putting the industry on a basis of profimbilicy,
for example where a
Government is ret .using a necessary price
.increase because of its effect
on the index of inflation. However, his should not
be undertaken
unless the positive results will accrue over the
longer term.
In some .-ountries, e.g. USA, Australia. Brazil,
Canada, tobacco
mxation is a mixture of Federal and Revonai. This
may offer
opportunities to trade off one auEhoncy against
another, either to
achieve lower overall taxation or beiter my credit
payment terms.
However, the relationships between the Federal and
Regional
authorit'es requires careful management since
disharmony between the
two authorities can equally lead to hiaher levels
of taxation and worse
crcdi, terms.
Level or Taxation
The combined forces of Government revenue needs
and the anti-
smoking lobby have resulted in increased real
levels of taxa6on in
many countries, a situation which is likely to
intensify further in the
foreseeable future.
Every opportunity to reduce the level of taxation
should be pursued
even though the achievement Of 7eductions may
never be easy. If the CD
taxable base can be expanded e.g. by including
smoking products not r)
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BATCo document for Province of British Columbia 23
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presently taxed or which are evading tax, then
Governments may be
persuaded to effect rate reductions on cigarettes
or not affect
increases.
Should reductions prove to be unachievable
companies should contain
the increase in taxation to a level below the rate
of inflation or at
worst in line with it.
Arguments supporting this include
the inflationary and regressive impact of tax
increases ahead of
inflation. particularly upon lower :ncome groups
who frequently
account for a disproportionately large amount of
tobacco sales:
- the normal zconornic arguments that tax
inc:eases result in
,allinz demand. employment, profitability and
investment, both
direcr!y upon the company and indi=_-ly upon
suppliers-,
:ncre--ses in :axation and hence retail pnct can
result in the
emergence or grow',h of transit or border trade
business and
hence a eall in revenue vield. This has very
dramatically been
illustrated recently in Canada. The high mKation
policy
followed bv the Canadian Government. in an effort
to reduce
smoking incidence, has failed and the high levels
of taxation
have been reduced, smuggling has largely 6een
overcome.
- I . g .
high tax increases may result in smokers dropping
out of the
manufactured cigarette market and switching to RYO
which is
often axed at a lower level or not at al!. It is
conceivable that
overall Government rectipts could fall in such
circumstances;
gh =,a6on will incentivise evasion. It is
essential to monitor
hig
competitor excise payment disciplines to ensure
that we are not
disadvantaged from either slower payment or
non-payment by
our competitors. Government should be advised of
evasion by
compention.
increases in zaxation which may result in a
decline in
consumption sufficient to bring about a fall in
revenue yield to
the Government. Because of the inelas:'city of
demand for
cigarettes. over the longer term, this result
rarely occurs.
However. it is not uncommon to see a short term
decline in
revenue yield which ran be pointed out to
Government when
opposing increases:
increases in taxation which reduce consumption may
mean the Q r"
destruction of the vitality of the tobacco
industry and thus the
erosion of the tax base which Government may wish
to protect cr,
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BATCo document for Province of BritiSh Columbia 23
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over the long term. This applies even more in
countries with a
significant leaf export trade which depends to
some extent upon
W~~ continued existence of the local industry.
- increases in taxation which are either out of
line with
international or regional norms or would result in
the incidence
of taxation becoming out of line with such norms.
It is BATCo policy that operatin, - companies
should not absorb
indirect tax inc-eases. These should always be
passed on, unless there
are very compelling reasons to the contrary.
Value Added Taxes ;VAT) are always ad valorem. In
many
countries. where Gove-nments are not confident of
collec:in ` the
VAT due from the wholesale or retail stages,
manutacturers 1~1-
required :o charge the :ax on wholesale or retail
prices. This can be
advantageous. it depends on the length of credit,
there can be cash
flow benefics and it 21ves rnanufacwrers a greater
degree of con:rol
over retail pnc,-s.
It is impor-anc, when VAT is applied to tobacco
products. to seek to
ensure :
a) that excise rates are reduced in compensation
b) that the tax regime allows the recovery of
input VAT on all
bus-Iness purchases
c) that the length of :redit adequately
compensates for the costs of
accouncin- for and collecting the tax
g , for the Government.
d) that the collection of VAT does not extend
beyond the
manufacEurin2 sraze, unless controlled bv the
manufac-urer as
noted above.
4. Excise Collection
In all countries. the --ming of excise payment is
crucial bemuse of its
cash flow and profit implications. The minimum
objective should be
to ensure revenue neutrality whereby tax is not
paid until payment has
been received from the distributive trade However,
one should
always press for a period of tax credit which is
positive, which covers
one's costs of administering and collecting the
tax on behalf of the
Government, which covers any bad debts (if any)
and which is U11
consistent with the concept of all indirect
taxation viz : that a C~
consumption tax should be paid when the product is
consumed, not r".:
when it is manufactured or still in the
distribution pipeline. There CN
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have been occasions where Governments have
increased the period of
tax credit instead Of permitting a orice incre=
(the latter being
inflationary) as a means of improving
profitability.
Experience of indirect tax systems demonstrates
clearly that it is
preferable to minimise the involvement of the
trade in the system so
chat the manufacturers essendally retain the
optimum influence over
tne final retail selling price. In Europe in
particular, the power and
influence of [he trade has and still continues to
grow with resultant
pressure upon manufacturers to give higher
margins, bonuses or other
incentive payments to the trade. One of the means
whereby the
influence of the trade has been contained is the
existence of an excise
collection svstcm whe-ebv only tz manufacturers
are involved. and
where the trade margin is Fixed zn:~er by law or
practice on :he basis
of the price determined by the rrnnufacturer in
agreement with the
Government. Attempts by he trad:! to be involved
in colic--*In-, and
pacing over excise ca-Y to :he Gove-nment should
be resisted strongly.
Where the excise is linked to the re:zul price of
a brand, (normally via
ar. ad valorem element) it is necessary to have
either a fixed retail
once for that brand or a recommeqded retail
selling price or an a-reed
price for the purposes of calculating the excise.
li~is is advisable ~50
because it mimmises :.~e ability ofthe trade to
reduce the retail price
and so pass on to the consumer the multiplied
effect of any price
sa,- ing. To be able to vary the pr-,ce upon which
the excise is based
and so vary the excise itse; r, would result in
the trade effectively
determining the retail price instead of the
manufacturer doing so.
Although bande-oles or Fiscal markers are not
desirable because of
teir negative impact upon manufac-uring
efficiencies, they may offer
some scope for resoivin.g the prob'em of smuggling
or evasion.
Relations %with Government and its advisors
Government officials responsible for tobacco
excise and VAT
planning and control, from a rellati~,ely low to
the highest level,
should be identified and sufficient regular
contact maintained while
Ministerial (Government & Opposition) contacts
should also be
maintained to ensure that the Company is well
placed to have its
views taken into consideration when policy is
being determined. Such
contact should be the responsibility of senior
management and the
Board to ensure an adequate level and quality of
communication.
CIN
BATCo document for Province of BritiSh Columbia 23
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An amicable and effective partnership between
company and
Govemment is the objective. Rather than reacting
to a problem, a
posiLive and pro-active approach to this subject
must be implemented.
Such relations should establish BAT as the Company
to which
Government will tum when they need advice and
assistance upon any
aspect of excise taxation, which of course
requires the existence of the
knowledge and experience of excise in the Company.
This is
becoming more significant as our competitors seek
to influence and
change Government policy on excise structures from
that which is
appropriate to BAT to that which is more
appropriate to their own
brand mix. Conversely, we should examine the
opportunities to
change excise systems too. if indeed such a change
would be
bene.,"icial. In ei-ner instancz, good and rtsular
Zovelnmenr relations
are essential.
In this same context, it is aiso relevanr to
maintain close contact with
manufac,urers of products also subjec, toexcise
taxation, particularly
alcohol, where there are many excise similarities
and where a joint
approach might have more impact. This is not an
easy situation to
bring about, but a good example of effecave
co-operation was the
successful lobby campaign for the ELT Dury Fret
exension.
increasin2ly the 'nluence of'INIF and World Bank
is being felt in the
a.rea or excise tax and VAT issues. Operacing
company management
must be aware of heir role and se;!~ to influence
decisions from these
bodies e.g. most often ad ~alorern systems are
proposed by
r,MF.,'World Bank. because of their belied, often
misguided. that such
svstems are the most simple and ma-ximise
Govemment revenues. If
this is not in our favour we must lobbv against
the proposals.
INIF/World Bank policies are mostlv direc-ed from
Washinvon DC
and Millbank is -szabiishinz contacts there. in
order to assist operating
Companies.
Operating company management should establish good
working
relationships with local representatives of
1',IF;World Bank/WTO
organisations to ensure that our position and
expertise on indirect tax
and trade issues is appreciated. Whenever possible
assistance and
advice should be given. A good relationship will
make any necessary
local lobbying more effective. Assistance should
be sought from
Millbank (Tobacco Taxation Department) if a
resolution of local
issues could be ex:)edited bv [he in,6olvement of
the inEemational H.Q.
of INIFiWorld BankiWTO.
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6. industry Relations
in a competitive context, tobacco excise taxation
is a key subject for
discussion and agreement in the National
Manufacturers Association.
Collective action and influence by the industry is
likely to be more
effective and productive than by individual
companies, although the
latter may also be appropriate from time to time.
Although the lead
company on excise issues Eends to se!ect itself on
the basis of market
share, it can also be an the basis of kmowledge,
experience, contacts
with Government. Where market share means that it
is not BAT,
companies should seek to ensure a lead position
through thew other
means. Excise contains many compiex aspects which
have to be
mastered if NNMA lead.-7shiD is to be
:!sLablished.
Althou-h the main thrust on excise s~.ould and
will always come from
the m;;ufacturers, some bene~a may be derived from
incorporating
naEural allies such as obacco z.armers.
orocessors. suppliers to the
industry, distributors and retailers in e lobbying
ac:ivities of the
NMA on --xcise leve!s.
Every opportunity for zhe Lndustry to aaree policy
and act collectively
should be taken. Howe-,er. it .agr=nent proves
impossible. it will be
necessary to devote the appropriate cornpany
resources to Government
relations to ensure that -.he Group pos-ion and
influence exceeds that
of the competition.
DJ Bishop
Ntarch 1995 C:)
BATCo document for Province of BritiSh Columbia 23
April 1999