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Copyright © 2005
Tobacco Outlet Business
Updated September 24, 2005
Fade To Black –
New federal and state legislation has outlawed one form of gray market cigarette sales, only to have another crop up in its place. By Jay Lynd
Picture this: One day you’re doing business as usual, selling large quantities of cigarettes at super slim margins. Business is steady and, while profits per carton can only be characterized as meager, you’re doing all right by keeping a close eye on inventory, carefully managing manufacturer promotions, and providing customers with good old-fashioned personal service. The next day, you discover that, through a loophole in the tax law, you’re able to buy "gray market" cigarettes, which means that brand name cigarettes that once cost you $24 a carton are now available for a mere $12.
Such a discovery can change a retailer’s life. "I bought a new Suburu with the money I made last year," says Glen McDonald, owner of Houston, TX-based Cigarettes for Less. "The wholesaler I was doing business with bought a Mercedes Benz."
Unfortunately,
for McDonald, his burgeoning profit center was short-lived. Congress and the State of
Texas both moved quickly to close the loophole. Congress’ act was decisive, a new
section for the Internal Revenue Code enacted January 1 that bans the reimportation of
domestically manufactured cigarettes by anyone other than a manufacturer. Debate now rages
as to whether the definition of "a manufacturer" is any manufacturer of
cigarettes or the manufacturer of the cigarettes being reimported. But additional
legislation passed in some 24 states (see sidebar, "Getting the Gray Out"),
including McDonald’s Texas, couples the federal restriction with laws prohibiting
state cigarette tax stamps from being applied to cigarette packs that do not bear the U.S.
Surgeon General’s warning and/or are marked "For Export Only."
In the wake of such restrictions, most retailers opted to pocket the money they’d made and quit the gray market game. "I’m getting off the high I was on and going back to reality," says McDonald. "Most loopholes in the law are very lucrative, and most get closed eventually. There was a ton of money made, but right now the gray market is over in Texas."
But, as it turns out, there are different shades of gray. As soon as one form of "gray market" cigarettes-those manufactured in the U.S. and designated for export, then exported and reimported into the U.S.-were made clearly illegal, another form hit the streets. These are cigarettes carrying U.S. brands that were manufactured outside the U.S. and intended for sale in non-U.S. markets, but which are imported into the U.S. With both types of gray market cigarettes, all applicable taxes and duties are paid; the cost savings is derived from the difference in pricing of U.S. cigarettes, which include increases related to the state settlement, and non-U.S. market cigarettes, which don’t incorporate such price hikes.
At present, the sale of such cigarettes is perfectly legal, particularly in states that have yet to adopt gray market restrictions-and can be highly profitable for those who choose to market them. "The new federal law prohibits the reimportation of U.S. manufactured cigarettes destined for export, but has no restrictions on the import of gray market cigarettes manufactured in other countries," explains Tom Briant, who serves as executive director of both the Minnesota Wholesale Marketers Association, Inc., and the Minnesota Tobacco Store Association. "It’s my understanding that what’s now happening is that cigarettes made in Switzerland under a licensing agreement with Philip Morris-referred to as ‘American-blend Marlboros’ by the Florida District Attorney-are being imported into the U.S. by third parties unrelated to Philip Morris."
"Because these cigarettes are not subject to the significant price increases occurring in the past year and designated to pay for the state settlements, they are priced lower," he adds. "We’re seeing price differences at retail of $2 to $4 a carton less than domestic brand cigarettes."
While the sale of "American blend" gray market cigarettes is perfectly legal, the activity is reportedly not sanctioned by manufacturers. "The wholesalers and retailers in my association are not allowed to sell these cigarettes or they will lose their contracts from the manufacturers," asserts Briant, who explains that the prospect of high-margin, high-quantity cigarette sales has spawned "gray market-only" retail and wholesale businesses. "We have 64 wholesalers licensed by the Department of Revenue in Minnesota; three of those sell nothing but gray market cigarettes. They don’t have a concern about losing manufacturer contracts because they’re dealing primarily with gray market product and don’t have agreements with the U.S. manufacturers."
This recent development in tobacco retail has proved detrimental to both legitimate tobacco retailers, who can’t match the prices offered by the gray market competitors they face, and to state tax coffers, which are seeing declines in their settlement payments from manufacturers. "The retail members of our association who are under contracts can’t sell these cigarettes and it makes for a difficult competitive situation," reports Briant. "They are incurring significant losses in terms of sales. The price differences are so great even the manufacturer buydowns don’t allow them to compete."
Statistics showing a rise in cigarette imports support this allegation. In 1998, imports into the U.S. totaled 4.57 billion cigarettes; in the first three months of 1999 alone (the most recent data available), 1.859 billion cigarettes were imported, which translates to an estimated annual figure of $7.4 billion cigarettes-a dramatic increase in just one year. "That’s a significant upturn," says Briant. "We believe gray market cigarettes represent a good portion of this increase."
The import increase has state tax departments across the nation on the alert. "Under the settlement agreement the cigarette companies entered into with the states, there is an adjustment formula that says if domestic sales decline, the payments will also decline, based on a formula," says Briant, who reports that Minnesota’s first payment in 2000 showed a decline of $30.5 million.
A recent financial statement by Philip Morris acknowledged the problem, noting that "PM USA estimates that gray market activity represents 1% of total industry volume in 1999. Also, gray market activity affects Philip Morris more proportionately than the other cigarette manufacturers because of the popularity of Marlboro. We feel, however, that gray market activity should have less of an influence in 2000."
In the meantime, retailers tend to fall into one of two categories when it comes to gray market sales-those who do and those who don’t. "We have a lot of people who call and ask if we have them or come in with a pack and ask if I can bring them in," says Rebecca Smith of Smoke ‘n Suds East in Boise, ID. "Philip Morris denies that they sell them and says stores who sell them won’t get contracts. But Cigarettes Cheaper carries them, and they are a Philip Morris store, so I don’t think it’s enforced."
Smith is also dubious about the quality of the gray market cigarettes. "It’s a totally different blend," she asserts. "What happens after a while is that people find out that they’re really crummy cigarettes."
Legislation has also gone a long way toward eliminating gray market cigarettes in many states. David Bershof of Colorado-based Smoker Friendly, who took a proactive stance on getting such legislation passed, says gray market sales ceased to be a problem for his stores after the legislators "put some teeth into the laws." As a result, gray market competition went from being one of the biggest challenges his company faced to being virtually nonexistent. "We were able to overcome it by working closely with legislators in different states and getting them to understand how it would affect their portion of the settlement," Bershof told TOB in January. "Of course, it also wasn’t helping the day-to-day business man in trying to make a living in this business. The key that put a damper on the market was getting it in the bill that they would confiscate the product."
Thanks to fair market rulings, retailers in many states are protected to some extent from unfair competition even when gray market cigarettes are on competitors’ shelves. "We avoid gray market product," reports Patricia Schimelfenig of Cherry’s Discount in Old Forge, PA. "Pennsylvania has a state minimum, so you can’t sell under that. Retailers may be carrying gray market cigarettes and just enjoying a higher profit, but they can’t beat us on price."
Of course, there are still those who are ready and willing to take advantage of the profit potential of gray market cigarettes-just as soon as they can figure out a way to do it legally. A group of national and international discount cigarette distributors are talking the issue to the courts. February saw the filing of their multibillion dollar lawsuit against the big five tobacco companies, and 47 other defendants who represent the state agencies charged with the enforcement of the terms of the Masters Settlement and Model Acts. Charging violations of the First Amendment and the Import/Export Clause of the U.S. Constitution, the suit alleges that the "state agencies, Attorneys General, National Association of Attorneys General and tobacco companies are engaging in a collusive monopolist practice to limit and exclude competition from the plaintiffs..."
And then there are those who simply plan to scrutinize the law, seeking a safe path around the restrictions. "Personally, I’m searching right now for another loophole in this law that they made," says MacDonald. "My wife is an attorney and we just about have it figured out." à
| Getting the Gray Out Sometimes one law just isn’t enough. While an act of Congress (in the form of a new section of the Internal Revenue Code, section 5754) taking effect January 1, attempts to curtail gray market activity by prohibiting reimportation of U.S. made cigarettes by anyone but cigarette manufacturers, two loopholes in the ban have already surfaced. First, while U.S.-manufactured Marlboros, for example, can no longer be re-imported, Marlboros manufactured overseas through licensing agreements can still be legally brought in and sold in the U.S. Second, gray marketers are beginning to question the wording of the federal bill, arguing that the ruling allows any cigarette manufacturer to re-import cigarettes, not only the original, manufacturer of a particular brand. If the Bureau of Alcohol, Tobacco and Firearms ("BATF") interprets "a manufacturer" to mean any manufacturer of cigarettes, importers may seek to achieve manufacturer status to circumvent the restrictions. Furthermore, since section 5754 only addresses the issue of reimportation of cigarettes, those with inventories of gray market cigarettes acquired before January 1, 2000 will be able to continue selling them. Since most companies were well aware of the pending act well before it took effect, many were able to stockpile supplies of gray market cigarettes. What’s a state that’s losing a big chunk of its share settlement money to gray market sales to do? At least 24 are fighting back with their own regulations on gray market sales, most of which add weight to the ban with plans to confiscate contraband cigarettes. The Oklahoma Senate, for example, passed a bill that bans the sale of gray market cigarettes in Oklahoma and authorizes the seizure of gray market cigarettes. The bill followed Philip Morris USA’s distribution of a position paper to Oklahoma lawmakers saying gray market products have "an unfair competitive advantage over those who obtain product through the normal chain of distribution and sell product in the original manufacturers’ packaging that complies with applicable federal laws pertaining to health warnings and packaging." The bill was not without opposition. Oklahoma State Sen. Gene Stipe said he feared it could hurt small businesses’ ability to compete with larger discount stores. Other states choose to educate consumers about the differences between brands made for export and those intended for domestic sale. "The ‘gray market’ has the capacity to attract many consumers believing that they are getting the same products for less Florida Deputy Attorney General Richard Doran told the Fort Lauderdale Sun-Sentinal, noting that, although the packaging may look the same, gray market cigarettes are often stronger than those manufactured for domestic sale, containing more tar, nicotine, and other chemicals. Manufacturers are also chiming in. In addition to warning their wholesalers and retail customers that their contracts will be terminated if they deal in gray market product, Philip Morris, R.J. Reynolds, and Brown & Williamson have filed lawsuits in several states against distributors that deal in gray market versions of the companies’ most popular brands, such as Marlboro and Camel. The lawsuits allege trademark infringement, unfair competition, trademark dilution, and unlawful importation. à |