SD5 - Illegal Cigarette Trafficking

Executive Summary:
During the 2012 Regular Session of the Virginia General Assembly, Senate Joint Resolution 21 was enacted, which directed the Crime Commission to study and report on a number of topics involving the subject of illegal cigarette trafficking. The Commission was mandated to determine: why illegal cigarette trafficking occurs, the methods and strategies used by traffickers, the beneficiaries of trafficking, the health implications of non-regulated cigarettes, methods used to counterfeit cigarettes and tax stamps, potential uses of information technology to prevent cigarette trafficking, and statutory options that Virginia could adopt to combat the problem.

All cigarette trafficking schemes, regardless of the scope of the operation or the methods employed, depend upon tax avoidance to generate illegal profits. Traffickers exploit differences in tax rates between different jurisdictions or geographic locations, purchasing cigarettes in one area and then illegally transporting them to another area where the tax rates are higher. The difference in the tax rates creates the profit for the trafficker, who is also able to sell his cigarettes at lower than market prices. The lower prices, in turn, provide an incentive for retailers and consumers to purchase these black market cigarettes. Retail merchants who purchase trafficked cigarettes gain an unfair economic advantage over their competitors, due to the lower prices they can offer customers. The customers, in turn, may be unaware that these low-cost cigarettes are black market items, and may simply think they have found a great bargain.

Cigarette trafficking can occur at all points along the normal production and distribution channels, with cigarettes being diverted outside normal commercial streams and into the black market. Manufacturers can produce “off the book” cigarettes, failing to pay the taxes on them. Wholesalers can similarly falsify records, under-reporting the quantities of cigarettes purchased and then re-sold. Retailers can sell some or all of their cigarettes “off the books,” thereby avoiding the payment of sales tax. And, individuals can purchase large quantities of cigarettes in one area, at the retail or wholesale level, and then transport them to another area or state, a process sometimes referred to as “smurfing.” When individuals purchase their cigarettes at the wholesale level, sometimes creating fictional retail businesses to do so, they deprive the state of tax revenue. When this occurs, not one, but two states are made the victims of tax evasion—the state where the cigarettes were purchased, and the state where the cigarettes were transported.

To achieve lower costs, traffickers can arrange for their cigarettes to be manufactured overseas. Frequently, these cigarettes are counterfeits. The packaging used in popular brands of cigarettes is duplicated; however, the cigarettes inside will differ substantially from the genuine articles. A number of recent studies have reported that the manufacturing facilities used in the production of counterfeit cigarettes have little or no quality control; the counterfeit cigarettes, in turn, have alarmingly high levels of contaminants, including dangerous levels of toxic metals. In short, counterfeit cigarettes present a serious public health risk.

The recent increases in state cigarette excise taxes in the north-eastern states have created a situation where Virginia has become a primary source of cigarettes for traffickers in the United States. Virginia currently has the second lowest state tax rates on cigarettes in the country, after Missouri. Meanwhile, New York, Rhode Island, and New Jersey have some of the highest cigarette tax rates in the country. In the past two years, a number of studies, some academically published in peer-reviewed journals, have determined that Virginia is currently the largest single source of out-of-state, black market cigarettes in New York City. By some estimates, up to 30% of all cigarettes purchased in New York City are black market; of those, over half may be trafficked from Virginia.

The profits that can be generated by exploiting the differences in tax rates between Virginia and the states north of the Commonwealth are staggering. The state excise tax rate for a carton of cigarettes (10 packs) is $3.00 in Virginia; in New Jersey, it is $27.00; in Rhode Island, it is $34.60; and in New York, it is $43.50, while in New York City, it is $58.50. Traffickers can therefore realize a profit of around $100,000 for a smuggling run from Virginia to New York City, transporting in a car or van just 1,500 cartons of cigarettes. In turn, a tractor-trailer filled with cartons of cigarettes represents a potential profit of a few million dollars.

These large amounts of money have proven irresistible to organized crime. Law enforcement intelligence reports have indicated that gangs and other organized crime rings have increasingly begun to focus their efforts on cigarette trafficking as a source of revenue. The profit margins on black market cigarettes are now greater than for cocaine, heroin, or illegal firearms. If organized crime continues to view Virginia as an ideal location to obtain cigarettes, their habitual presence may lead, in turn, to increases in attendant crimes—robberies, burglaries, credit card fraud, and money laundering.

The tax stamp that Virginia currently uses on cigarette packs has a number of security features, which can assist law enforcement in determining if a particular stamp is genuine or counterfeit. Tax stamps with higher security features, and with digital encoding capabilities, exist. However, there are associated costs with the use of high-tech tax stamps, and most of the information which a digital stamp could provide can currently be obtained with Virginia’s existing stamps, albeit with more effort, such as tracing the serial number on a stamp back to the wholesaler. As almost all data and law enforcement intelligence indicates that Virginia is a source state for trafficked cigarettes, and not a destination state, switching to a digital tax stamp would probably not have a significant impact on Virginia’s tax revenues.

However, technology could be used to assist manufacturers, wholesalers, and the Virginia Department of Taxation in expediting the filing of mandatory reports, and in facilitating the payments made by wholesalers for the tax stamps which they affix to packs of cigarettes. Currently, the mandatory reports made by manufacturers and wholesalers to the Virginia Department of Taxation and the Office of the Attorney General of Virginia are generated in paper format, and sent by mail. In a similar manner, the payments made for tax stamps by wholesalers could be submitted to the Virginia Department of Taxation electronically.

The Crime Commission reviewed study findings at its September 5, 2012, and November 13, 2012, meetings and directed staff to draft legislation for several key issues. As a result of the study effort, the Crime Commission endorsed the following legislative recommendations at its December 5, 2012, meeting:

Recommendation 1: Amend Va. Code § 58.1-1017.1 for the possession of stamped cigarettes with the intent to distribute by raising the current penalty from a Class 2 misdemeanor to a Class 1 misdemeanor, and making the Class 1 misdemeanor for a second or subsequent offense a Class 6 felony.

Recommendation 2: Amend Va. Code § 58.1-1017.1 for the possession of stamped cigarettes with the intent to distribute by making a first offense that involves more than 500 cartons of cigarettes a Class 6 felony, and making the Class 6 felony for a second or subsequent offense a Class 5 felony.

Recommendation 3: Amend Va. Code § 58.1-1017 for the possession of unstamped cigarettes with the intent to evade taxes by making the existing Class 2 misdemeanor a Class 1 misdemeanor, and making a second or subsequent offense a Class 6 felony; and by making a second or subsequent offense of the existing Class 6 felony a Class 5 felony.

Recommendation 4: Amend Va. Code § 58.1-1017 for the possession of unstamped cigarettes to evade taxes by lowering the current felony threshold amount from 3,000 packs (300 cartons of cigarettes) to 500 packs (50 cartons).

Recommendation 5: Amend Va. Code § 18.2-513 by including Va. Code § 58.1-1017.1 in Virginia’s RICO statute.

Recommendation 6: Amend Va. Code § 19.2-386.21 by allowing for the forfeiture of property used in connection with cigarette trafficking.

Recommendation 7: Amend Va. Code § 18.2-246.14 by making the distribution, or possession with the intent to distribute, counterfeit cigarettes a Class 1 misdemeanor, for quantities of less than 10 packs. Quantities of 10 packs or more would be a Class 6 felony, and a second or subsequent violation of the statute, after a previous conviction, would also be Class 6 felony, regardless of the number of counterfeit packs involved.

Recommendation 8: Wholesalers and manufacturers should be permitted, but not required, to file their mandatory reports electronically, provided the receiving agency chooses to allow this as an option. Cigarette wholesalers who are stamping agents should be permitted, but not required, to submit their payments electronically, provided the Virginia Department of Taxation chooses to allow this as an option.

In regards to policy recommendations, the Crime Commission endorsed the following:

Policy Recommendation 1: Increase efforts to combat cigarette trafficking in the Commonwealth, including through allocation of additional resources to agencies that are responsible for investigating this area of crime.

Policy Recommendation 2: Ensure that law enforcement receives adequate training on the subject of cigarette trafficking. A formal letter will be sent to DCJS, recommending that they help to coordinate this training.

Policy Recommendation 3: Encourage the Virginia State Police to consider developing an information sharing system, accessible only to law enforcement that would allow for the collection of raw data and criminal intelligence on cigarette trafficking. A formal letter will be sent to the Virginia State Police, inquiring if the general proposal to develop a law enforcement information sharing system focused on cigarette trafficking is feasible.