PRELIMINARY DRAFT
BOTEC Analysis CORPORATION
73 FAYERWEATHER ST. CAMBRIDGE, MA 02138 LOWRY HEUSSLER, GENERAL COUNSEL
617/245-8567
[email protected]
CALIFORNIA TOBACCO ENFORCEMENT 1/6/2013
Merle Frank, Steve Davenport
1
PRELIMINARY DRAFT California Tobacco Enforcement
Summary Even at current taxes (not very high in California) and with no menthol ban, California has an active and possibly growing illicit tobacco market with a gross retail value of roughly at least $600 million. Preliminary investigations suggest that the state does not currently have a well-coordinated, multijurisdictional strategy to enforce the law against participants in that market, and that local agencies may possibly lack sufficient resources to keep it from growing. California's licensing scheme appears to have reduced illicit activity among licensed tobacco producers, distributors, and retailers. Especially since the implementation of AB 71 in 2007, this framework has facilitated effective and economical inspections and penalties of license holders. California's tax stamp has yet to be successfully reproduced, and a central database allows for quick and accurate verification of the tax-paid status of any pack of cigarette. On the other hand, at least some illicit sales of cigarettes continue at unlicensed retailers, and rates of counterfeit in other tobacco products (OTP) remain very high relative to that observed with cigarettes. Cigarette and tobacco crimes appear to be mostly neglected by the surveyed local law enforcement agencies, and it is likely that reflects the situation statewide. This is probably the result of dramatic budget cuts to many police and sheriff budgets. Specific focus directed against illicit tobacco crimes is, however, brought by a "tobacco crimes" task force that includes the California Board of Equalization (BOE), the Northern District-CA US Attorney's Office, the state Attorney General's office, ATF, and IRS. In addition, the LA City Attorney's Office and the LAPD's Anti-Piracy Unit reportedly also dedicate significant resources against the problem. The fact that each of these units opens approximately five tobacco-related investigations per year suggests that, even if current illicit tobacco markets are now being held in check, a substantial increase in illicit activity might overwhelm the state's enforcement capacities.
Methodology We contacted a number of California's biggest police, sheriff, and tobacco law enforcement agencies during the conduct of this study. Respondents were asked a
series of short questions designed to elicit agency estimates of (1) the size and importance of the illicit tobacco market and (2) the resources and activities of any units devoted to controlling that market. Responses were received from a number of local agencies - Sacramento Sheriff, Santa Clara Sheriff, Oakland Police Department, San Diego Police Department, San Jose Police Department - and some state and Federal agencies, namely the ATF, the California Board of Equalization, and the 2
PRELIMINARY DRAFT California Attorney General's office. Other local agencies - including the San Francisco Police Department, Los Angeles Sheriff, and the San Diego Sheriff - have provided information by phone but have not yet delivered formal survey. Consulted experts include the chief economist at the California BOE, a Deputy Attorney General (DAG) with the primary responsibility of criminal tobacco enforcement, and a program manager of investigations at the BOE. In addition to these direct inquiries, our analysis uses official reports from the BOE.
Size of the illicit tobacco market Collected and Lost Revenue
In FY 2010-11, the BOE collected $77 million in licit OTP tax revenues and $828 million in licit cigarette tax revenues. 1 In its most recent attempt (FY 2005-06) at estimating the revenues lost to tobacco tax evasion, the BOE estimated $182 million from illicit cigarettes and $94 million from OTP; therefore, approximately 18% of Cigarette purchases in that year were untaxed. 2 (This represents a dramatic improvement from 2003, when the BOE estimated $292 million in lost revenue from Cigarette tax evasion alone.) Although a new estimate might furnish different numbers, expert opinion suggests that there are few clear indications that the illicit tobacco market or lost revenues have either shrunk or grown markedly since. 3 Mechanisms of Evasion
A portion of those lost revenues represent evasion by the consumer (who directly transport tobacco from a low-tax place to a high-tax place for personal consumption). Since tobacco trafficked for personal consumption is never re-sold, it is more difficult for enforcement agencies to detect and penalize. Tax evasion in cigarettes is disproportionately handled by consumers, compared to that in OTP: in 2007,31 % of cigarette evasion was carried out by consumers, as compared to only 7.5% of evaded OTP.4 Thus, an estimated $212 million in tobacco taxes was evaded by retailers in FY 05-06, consisting of $125 million in cigarettes and $87 million in OTP. By those numbers, retailer-evaded cigarettes amount to $375 million in value, or 12 % of the all cigarettes sold. 5
Board of Equalization. June 2007. Revenue Estimate. Cigarette and Tobacco Products Tax Evasion. http://www.boe.ca.gov /pdf/cig-evasion-07.pdf 2 Ibid. 3 Conversation with chief economist, California Board of Equalization 4 Ibid. 5 Source: DAG with primary responsibility of criminal tobacco enforcement. The tax on a pack of cigarettes represents approximately 35% of the pack's retail value. 1
3
PRELIMINARY DRAFT Growth Trends There is no statewide estimate of the size of the illicit tobacco market, a fact which itself suggests the limited scale of the current enforcement effort. Different agencies offered different opinions about trends: the LAPD estimated that the problem was growing, while the AG responded that it was shrinking and the BOE reported that the problem was either shrinking or staying the same. From the perspective of the "tobacco crimes" task force, successful prosecutions of flagrant tax-evaders of OTP have succeeded in discouraging this behavior, thereby lowering the acceptable standard for tax evasion. The relatively low sophistication and lack of criminal experience of OTP distributers and retailers may contribute to their high level of responsiveness to increased criminal risk. 6
Methods of Evasion Indian Reservations Native American reservations are often cited as a major source of contraband cigarettes, owing to their exemption from state taxes and inspections'? According to this scheme, Indian reservations acquire tobacco licitly from licensed manufacturers, taking advantage of tax exemptions designated for tobacco distributed only to residents of Indian reservations. The tobacco or cigarettes are then legally transferred across state lines to other reservations without any additional taxes, thereby ensuring a flow of cheap, tax-evaded cigarettes throughout the country. Once the product has been distributed in this manner, it is very difficult for State or Federal enforcement authorities to prevent the sale of these tobacco products to non-Native Americans. For instance, CA BOE investigators are not authorized to carry out administrative inspections of licensed retailers, distributors, or wholesalers based on reservations. (However, California law enforcement can legally conduct enforcement activities where they can establish probable cause related to the commission of a crime.) Other sources o/illicit supply Anecdotal evidence suggests that most counterfeit cigarettes are produced in and imported from China. 8 Counterfeiting and international trafficking are expensive, industrial activities, requiring greater amounts of capital and coordination. Source: DAG with primary responsibility of criminal tobacco enforcement. Conversation with task force member, who had heard anecdotal information from prosecutions and other cases. 8 Source: DAG with primary responsibility of criminal tobacco enforcement. 6
7
4
/
PRELIMINARY DRAFT Accordingly, the criminal entrepreneurs behind these activities are likely more sophisticated and organized than those participating in border crossing and OTP "blending" schemes. It is conceivable that these foreign-made counterfeit cigarettes are imported inside mislabeled pallets and shipping containers, although the scale of this activity is difficult to estimate. The sheer volume of cargo passing through ports makes random inspections extremely unlikely to detect contraband tobacco, so enforcement against this route of traffic relies primarily on informant reports. BOE believes that the tobacco tax stamp, combined with the inspection regimen, has prevented counterfeit cigarettes from becoming a significant factor in the state's retail market. In addition, the absence of counterfeit cigarettes from licit retail outlets likely prevents ready access by minors. Lastly, anecdote suggests that many cigarettes are smuggled into America via the Mexican land crossing. By this method, a smuggler might pack the trunk of a car with cartons of Mexican-bought cigarettes and drive North across the border for resale in America.
Scale of the Enforcement Effort No police or sheriffs department reported having a unit with tobacco trafficking as its first priority, and only the LAPD identified a unit with this trafficking as a second priority (its anti-piracy unit). Accordingly, in the rare event that local law enforcement responds to counterfeit or tax-evaded tobacco, most police or sheriff simply hand off the case to Federal authorities. 9 On the other hand, the LAPD's antipiracy unit frequently handles cases with counterfeit tobacco; however, in discovering the illegal activity, the agency relies heavily on tips from private investigators. 1o Recent budget cuts to police and sheriff departments do not seem to have directly affected local departments' capacities to control illicit tobacco, since most of them never had resources devoted to illicit tobacco control in the first place. 11 The ATF reported its capacities had been reduced in recent years, and the BOE reported that their funding and capacities have remained consistent. However, many departments reported cuts to their investigative and vice divisions, whose reduced capacities have no doubt indirectly hindered the departments' ability to identify and respond to illicit tobacco crimes. In the survey, agencies were asked what percentage increase in resources would be required to monitor illicit tobacco activity. Of agencies that answered the question, all reported a need to increase funding. Answers ranged from 20% from the Phone interviews with police and sheriff. Source: LAPD Anti-Piracy Unit detective 11 General findings from survey effort
9
10
5
PRELIMINARY DRAFT California Attorney General's office to 100% from the Sacramento Sheriff's department Six of the nine responding agencies identified the tobacco problem as "important;"12 the other three declined to estimate. Both the tobacco crimes task force and the LAPD anti-piracy unit report that they have plenty of targets and are not at risk of excess enforcement capacity. The tobacco crimes task force in particular sees more cases than it could handle to prosecute, and the task force brings in more tax revenues than it requires for operation. However, this seemingly stable state could rapidly transform if illicit activity increases, for instance if California levies additional taxes or a ban on menthol cigarettes. (The drafters of 2011's failed Proposition 29 followed this logic, allocating a small portion «1 %) of revenues to the tobacco crimes task force.)
Enforcement Agencies and Activities California Board of Equalization
Rather than focusing on tobacco crimes in particular, the CA Board of Equalization (BOE) targets the illicit economy in general. To suppress this activity, the BOE has adapted a strategy based on collaboration with local, State, and Federal agencies. (It is a member of the tobacco crimes task force discussed below.) The BOE's capacity to identify and respond to cases of tobacco tax evasion has escalated dramatically in the past fifteen years, due mostly to increased resources and the passage of AB 71.1 3 Passed in 2004 and implemented in 2005, AB 71 increased the number of full-time investigators, enhanced the administrative penalties for tobacco tax crimes, and initiated the development of a credible California tax stamp. All of these features have dramatically enhanced the BOE's ability to enforce tobacco tax laws. • Increased Staffing: In 1995, the BOE employed twelve staff members working on tobacco; today, the BOE employs an inspection workforce of 50 full time employees, 40 of whom are inspectors. • More Frequent Inspections: The BOE makes 10,000 inspections annually, or about one retailer-inspection every 3.5 years. • An Uncompromised and Trackable Tax Stamp: Although various visual duplications have been made of the stamp, there have been no reports of a successful workaround to the scheme's strong point: a trackable central database of all serial numbers. The system includes 800 licensed wholesale retailers, 200 distributors, and 36,000 retail locations; each licensee pays $10,000 annually, and only licensed distributors can acquire and affix tax stamps. Each stamp is assigned a unique, trackable ID used to trace its course from distributor to wholesaler to retailer. 12 Options were "critical," "important," "not very important," and "not an issue." 13 Source: Program manager for investigations at BOE. 6
PRELIMINARY DRAFT •
Increased revenues: Revenues increased in the law's first year of implementation, but have remained stable since then.
The BOE conducts regular inspections of licensed retailers to check for tax stamp violations (for cigarettes) and proper inventory invoicing (for OTP). Tax stamp inspections are carried out very effectively with scanners; accordingly, detected violation rates are relatively low. Violations fall into two categories: unstamped product and product with counterfeit tax stamps. Table 1 shows the numbers of seizures for each type over the past four years. Table 1. Contraband Cigarette Trend (Number of Seizures) 90 .---------------------------------------------80
+---~~~--~------------------------
70
+-------------------~~-----------------------
60
+-----------------------~~------~~~-------
50
+----,k---------------------~----------------
40
+-----------~~~----------------------------
30
+-__________________
20
+-------------------------~~-----------------
10
+----------------------------------=~~~----
...... Counterfeit Stamp ..... Unstamped
-3~----------------------
o +----------,r---------~----------.---------~ FY 08-09
FY 09-10
FY 10-11
FY 11-12
OTP inspections require matching stocked inventory against proper and recent taxpaid invoices, allowing for a tax evasion tactic known as "blending," in which taxevaded product is kept off-site and mixed in with tax-paid product as licit inventory is sold off. Although blending tactics are undetectable if performed correctly by retailers, the tactic is increaSingly cost-intensive as the desired ratio of illicit-to-licit product increases. Retailers involved in blending must make repeated trips to an off-site location to transfer tax-evaded product into inventory and face the risk that they may accidentally mismatch their illicit inventory with their licit tax-paid invoice.
7
PRELIMINARY DRAFT In the past two years, quantity and value of seizures by the BOE Cigarette & Tobacco Products Inspection Program are down dramatically, although number of inspections has remained constant. 14 Seizure incidents, quantities, and values remained relatively constant from 2006-10, and then established a new pattern in 2011. Table 2 displays the sharp contrast in levels of activity before and after 2010; table 3 displays the volumes of inspections and seizure activities from 2004 to present. Table 2. 2011 -12 Inspections activity, as a portion of2006-10 activity. 120% ,-------------------------------------------------------- -
100%
+---------------------------------------------------------
80%
60%
40%
20%
0%
Inspections
Cigarette Seizures
Packs Seized
aTP Seizures
Value aTP Seized
14 BOE Investigations Division. Cigarette and Tobacco Products Investigation Program. Data. http://www.boe.ca.gov/invest/inspectionprog12.htm
8
PRELIMINARY DRAFT Table 3. Cigarette inspections activity, . - .............. ---_ _ _ _.... _-_ ......._..............._ - _ 2004-2012 . _ _._-...__ .._._ ........
I
... ... ..........
..................•
........... ... _......
....... .......
..... .
40,000
I 35,000 30,000 ..l..--- \ - -- - --
-
-
- --
-
-
- -- -- -- -
25,000 -Inspections 20,000 + - --
- \,.,---
- --
- - --
- - - --
- - --
Cigarette Seizures
15,000
-Tens of Packs of Cigarettes Seized
10,000 +....................--".,....- .........- .....,..
5,000 . ;--.----.-...:oi••;,z-- - --
- ..- - - --
- .....- ...- -..-
-\-- --
o . . . . . . . . . . . .....['. . . . . . . . .. . . . .;.-........................... . . . ....,. . . . . . . . . . . . . . . . . . . . . . ......................... . . .. . . . . .. . . . . . . ;_ . -, 2004
2005
2006
2007
2008
2009
2010
2011
2012
Penalties for violation range from the civil to the criminal, based on severity. However, some localities issue more severe penalties than others. For instance, the BOE considers the tax evasion of 100 packs of cigarettes an egregious violation; some localities set this threshold higher, and others lower. In order to ensure consistent and fair consequences throughout the state, the BOE will "equalize" local justice outcomes by supplementing exceSSively parsimonious punishments from localities with additional state penalties. Typically, the BOE ensures that the first egregious offense receives a 10-30 days suspension, and that retailers failing to provide invoices for OTP are automatically issued a citation. Other possible administrative consequences include 30-day license suspensions, revocations, and fines of up to $5,000. California's unusually severe system of civil/administrative penalties for these violations greatly facilitates with their efficient administration,l5 BOE agents are unarmed. For protection in high-risk enforcement actions, the agency requests the cooperation of CHP or other local agencies.
15
Project manager for investigations at BOE. 9
.
ex 10) I
PRELIMINARY DRAFT Tobacco Crimes Task Force
The primary statewide provider of illicit tobacco-related law enforcement is an ad hoc task force that is referred to in this paper as the "tobacco crimes task force." Convened in 2008, its members include a Deputy Attorney General, two Assistant U.S. Attorneys, four ATF agents, five BOE investigators, and occasional participation by members of the IRS. • In FY 09-10 (starting March 2010), the task force filed four criminal cases in US District Court for "federal offenses related to California tobacco tax evasion," valued at $9.8 million. The investigation division had three investigators investigating trafficking of cigarettes. 16 • In FY 10-11, they filed 11 criminal cases, described as "federal offenses related to California tobacco trafficking and tax evasion," valued at $35 million and representing a total of 333 separate violations,17 • One of the criminal trials concluded in 2010-11 (ostensibly having opened in 09-10) found the defendant guilty on all counts, resulting in a court-ordered restitution of $3.7 million to the BOE.18 All cases have been brought federally, since federal authority allows for investigative grand juries, nationwide service of process, and use of the federal mail fraud statute. Federal prosecution is in part facilitated by cross-designating participating state prosecutors as "special assistant US Attorneys." As a result of these prosecutions, approximately fifteen defendants are currently serving time for tobacco trafficking crimes in California. In 2012, the task force opened five tobacco trafficking cases, on par with its average annual levels. In prosecuted cases, most schemes operate through the use of dummy corporations, false invoicing, and the filing of false excise tax returns. Examples of cases prosecuted by the task force (all of which are for OTP): • Simi Valley Tobacco Distributor Sentenced For A Scheme To Avoid Paying $528,000 In Excise Tax (Oct. 1, 2012)19 • Burbank Tobacco Distributor Pleads Guilty In A Scheme To Avoid Over $500,000 In Excise Tax (May 1, 2012)20 16 http://www.boe.ca.gov/annual!pdf/2010/2-highlightslO.pdf 17 http://www.boe.ca.gov/annual/2010-11/highlights.html 18 ibid. 19 CA AG. Oct. 1,2012. Simi Valley Tobacco Distributor Sentenced For A Scheme To Avoid Paying $528,000 In Excise Tax. http://www.justice.gov /usao/cae/news/docs/2012/10-2012/10-0112Humkar.html 20 CA AG. May 1 2012. Burbank Tobacco Distributor Pleads Guilty In A Scheme To Avoid Over $500,000 In Excise Tax. http://www.justice.gov/usao/cae/news/docs/2012/05-2012/05-0112 HarounGuiltyPlea.html 10
PRELIMINARY DRAFT •
Los Angeles Tobacco Distributors Plead Guilty In A Scheme To Avoid Almost $2.5 Million In Excise Tax (Feb 14,2012)21
The task force cannot prosecute all cases brought to its attention; accordingly, it focuses on the largest and most legally vulnerable cases. Accordingly, the task force has focused exclusively on OTP products. It has not opened any cases regarding tax evasion of cigarettes. The task force generally confines its focus to targets that have evaded a minimum of$100,000 in taxes, and some cases have ranged to approximately $10,000,000. By successfully prosecuting these flagrant offenders over the past few years, a member of the task force believes they have lowered the acceptable standard of evaded taxes. Due to this success, a source within the CA AG speculates that their focus could potentially shift toward cigarette smuggling. LAPD Anti-Piracy Unit
Housed within the LAPD's Vice Department, the anti-piracy unit generates and investigates individual cases for targeting street level vendors and distributors throughout the City of Los Angeles. Frequently, the unit receives cases from private investigators hired by commercial groups, rather than developing their cases independently. The Anti-Piracy Unit consists of five detectives and one police officer, 22 and it reported opening six cases targeted at tobacco trafficking in 2012. In contrast to the "tobacco crimes" task force, the anti-piracy unit focuses almost entirely on cigarette crimes, rather than OTP.
Conclusion California lacks a coherent multi-jurisdictional statewide strategy for dealing with illicit tobacco activity. Though there are signs that the aspects of illicit tobacco trafficking visible to California authorities have either held steady or decreased in scale, this stability is by no means certain nor permanent. There remains a significant potential for illicit retail at unlicensed mom-and-pop retailers, which are neither subject to license inspections nor actively patrolled by local police and sheriff. Moreover, there is no readily apparent solution to address the trafficking of untaxed cigarettes through Native American reservations; nor can the flow of foreign-counterfeited, untaxed cigarettes through the ports be easily quantified, let alone affected. On the other 21 CA AG. Feb 14, 2012. Los Angeles Tobacco Distributors Plead Guilty In A Scheme To Avoid Almost $2.5 Million In Excise Tax. http://www.justice.gov/usao/cae/news/docs/2012/02-2012/02-1412TobaccoTax.html 22 LAPD Blog, http://lapdblog.typepad.com /lapd blog/2009 104 /large-seizure-ofcounterfeit-pursesjewelry-recovered.html
11
PRELIMINARY DRAFT hand, state authorities appear confident in their ability to prevent the sale of taxevaded or counterfeit cigarettes at licensed vendors, and also in their ability to enforce a ceiling on the quantity of tax-evaded tobacco products other than tobacco. Due to the small number of the enforcing agencies - the "tobacco crimes" task force, the LAPD anti-piracy unit, the Board of Equalization - a significant increase in the incentive for illicit activities could potentially overwhelm their enforcement capacities. This holds especially true for street-level enforcement; while the "tobacco crimes" task force handles investigation and prosecution of larger cases and the BOE handles administrative penalties for license violations, the amount of resources devoted to street-level enforcement by local sheriff and police departments is close to nil. The potential size of the market for illicit tobacco in California merits additional research and analysiS. Specifically follow-up interviews with local enforcement agencies should be conducted, followed by analysis of regional and urban/rural patterns, and further contact with both the Los Angeles City Attorney and the ATF.
12
