South Africa’s Tobacco Tax Mess

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South Africa, one of the largest cigarette markets in Sub-Saharan Africa, has maneuvered itself into an unsavory tax-dodging situation unique in the world.

By Thomas Schmid

Many governments in Asia are concerned about the scourge of rampant cigarette smuggling and the sheer volume of illicit tobacco products flooding the various markets, costing them billions in lost tax revenues each year. But this appears to be nothing compared to the rather bizarre situation that seemingly has developed in South Africa. During the administration of President Jacob Zuma, South Africa experienced an unprecedented deterioration of state institutions and agencies, including the South African Revenue Service (SARS).

In June 2018, the former head of enforcement at SARS disclosed to a governmental commission investigating the agency’s tax administration and governance practices that in 2014 he had been “instructed from the very top of SARS” to stop inspections of cigarette factories. This created fertile ground for exploitation.

One particular point of abuse was the excise payment system itself, a so-called “duty-at-source” system under which SARS relies on manufacturers’ honesty in declaring their produced cigarette quantities. The payable excise duties are calculated based on these declared volumes. However, no longer watched over by SARS inspectors, some unscrupulous cigarette companies began to only declare a small part of their actual production volumes, therefore paying considerably less than they owed.

Startling figures of tax dodging

The figures involved are startling, as François van der Merwe, chairman of the Tobacco Institute of Southern Africa (TISA), a privately-funded body representing some of the region’s most high-profile tobacco industry players (see side box), explained. “In 2018, TISA members’ total cigarette consumption volume was approximately 15.5 billion sticks.

Non-TISA local manufacturers contributed a legal volume of another two to three billion sticks on top of that. Yet the total market in 2018 was estimated at around 30 billion sticks. The balance of about 12 billion sticks in 2018, therefore, was illegal or duty-not-paid,” he said. Meanwhile, South Africa’s total cigarette production volume for 2019 is anticipated to reach between 31 and 35 billion sticks, an increase of approximately 4% over 2018 – with the practice of unbridled excise tax dodging so far showing few signs of abating.

A quick sampling of small informal stores scattered across the country shows how serious the problem really is, with a pack of branded cigarettes routinely retailing for an average of only ZAR10 (US$0.66), often enough even less. However, the minimum collectible excise tax per pack in 2018 was set at ZAR17.85 (US$1.18), making it quite clear that such sales, in fact, ought to be illicit merchandise.

Illegal brand now top seller

In 2018, TISA commissioned market research company Ipsos to conduct a study in order to determine the true scope of the problem. The findings, which subsequently were widely reported by regional media, were eye-opening, if not to say mindboggling. The research, which recorded every single brand available in the country, showed an increase in illicit cigarettes in the informal market from 33.4% of total sales in June 2018 to 42% in October, i.e. within the time span of just four months.

Retail prices for illicit products were found to be “73% cheaper than the reference price in the legal market used by [the treasury department] to determine excise duties, and 44% cheaper than minimum taxes owed on each pack.” Furthermore, the study identified by name three particular local manufacturers who were swamping the market with their untaxed cigarettes. One of them, the study said, now represented “73% of the national market for illegal cigarettes.”

In fact, the flagship brand of the company in question had overtaken BAT’s Peter Stuyvesant as South Africa’s bestselling brand. Incredibly, this has made South Africa the first country and only country in the world where a brand selling mostly below taxes is now the top seller.

Far-reaching impact on many levels

The prevalence of the illicit trade in South Africa, of course, has a number of adverse effects on government, private businesses and society in general. “In financial terms, it is estimated that more than ZAR40 billion [US$2.65bn] in tax revenue has been lost to the illicit cigarette trade between 2010 and 2018,” TISA’s François van der Merwe told Tobacco Asia. “And that is a conservative figure purely based on excise duty and VAT on excise duty and does not take into consideration any associated taxes payable such as company or personal taxes that have also been evaded,” he added.

That money, he said, could have been used to fund much-needed infrastructure projects and services in South Africa. The government’s health agenda also is compromised, mostly because the market is flooded with cheap, illegal, unregulated, freely available cigarettes. But, it is also because – in some cases - products do not comply with regulatory requirements, specifically the absence of health warnings on packs, the products exceeding maximum permissible tar and nicotine levels, and non-compliance with reduced ignition propensity regulations.

Furthermore, van der Merwe elaborated that legal manufacturers’ market shares are negatively affected by the illicit trade, which results in reduced demand for local tobacco leaf, in turn causing job losses on farm level and in factories.

“The production volumes of TISA manufacturer members declined by more than 22% in the past three years while total consumption increased. This is a direct result of the growing illicit trade,” van der Merwe explained. “It impacts negatively on tobacco farmers and, if left unabated, may lead to the demise of the primary tobacco industry in South Africa. Flue-cured tobacco farmers had to reduce production by 15% over the past two years due to lower demand for legal cigarettes.”

Consistent, decisive, and coordinated action needed

So, is there any remedy or rectification in sight? “It will take time for SARS to become fully functional again, as audit and enforcement capacities have to be rebuilt and strengthened,” van der Merwe pointed out. “The new SARS commissioner, Edward Kieswetter, is leading the road to recovery, but he has an enormous task on his hands.” Modern new technology such as production counters installed on cigarette machines are an urgent first step required to ensure correct volumes are recorded so tax payments can be verified rather than solely relying on manufacturers’ submission of their output volumes, he said.

Apart from SARS having to rebuild its capabilities, other law enforcement agencies like the National Prosecuting Authority (NPA) also were on the slow but rocky road to recovery. Effective coordination amongst government agencies would be key to eventually achieve successful prosecutions.

Meanwhile, “the companies involved in illicit trade keep seizing the moment and will continue to do so until consistent, decisive, and coordinated action is taken,” van der Merwe said. But “given that all tobacco manufacturing inspections came to a halt between 2014 and 2017, [judicial] cases have to be reassessed and rebuilt. According to the revenue authority, the illegal tobacco trade in cigarettes is a priority area and much focus is placed to perform audits, investigations where required, and [eventually] take appropriate legal actions.”

T&T implementation postponed again

But legal prosecution aside, what South Africa requires above all else is a reliable tracking system to monitor cigarette manufacturing volumes as an effective countermeasure against tax dodging. However, that is easier said than done. In April 2019, SARS announced that it had embarked on several strategic initiatives to curb the country’s illegal tobacco trade, including implementation of a “track-and-trace marker technology” system.

But TISA warned that the T&T system would not address the core problem of the illegal trade, namely cigarette volume verification at point of manufacture. SARS nevertheless issued a request for proposals on 26 April 2019. But the deadline of 20 June for bidders to submit their tenders to be appointed as a single service provider passed quietly and without further news. According to an African News Agency (ANA) report published shortly after SARS’ tender announcement, van der Merwe had criticized that the revenue agency was attempting “to implement a system in 12 months that has taken the EU and Ghana more than four years of consultation and trials to achieve.”

He had also pointed out SARS’ intent to appoint a single service provider for an unprecedented eight years to implement a system that would impact wholesalers, retailers, distributors, and manufacturers at significant cost and without consulting the value chain stakeholders.

“Rolling out such a sophisticated, IT-intensive system requires enough time for preparation, consultation, and testing, and TISA is concerned that the rushed process being followed by SARS has skipped these critical steps,” he was quoted as saying in the ANA report. “It will impose excessive and impractical regulatory burdens on small retailers when the real problem lies with local manufacturers who are evading taxes.

This will only encourage retailers to sell illegal products because they won’t be able to cover the compliance costs of receiving legal cigarettes.” The track and trace tender process has subsequently been postponed twice, the latest date for submission now set for March 31, 2020, as the SARS commissioner wants to perform a full review of the entire process.

“TISA welcomes this step and remains committed to support SARS in finding a solution that would address the particular illicit trade problem in South Africa,” van der Merwe asserted.

The world’s first “eco-conscious” craft cigarette

While South Africa may be waging an uphill battle to reign in its illegal cigarette trade, a small South African company has made thoroughly positive headlines in recent months. Smokey Treats (Pty) Ltd. a while ago launched what it claims to be the world’s first “eco-conscious” cigarette brand, Woodland. The company was only founded in late 2015 with the ambition to tackle the earth’s most prolific source of ground litter and ocean waste, acetate tow cigarette filters. But it soon thereafter expanded on that scope as its craft cigarette brand took shape.

“Not only do Woodlands’ comprise a fully biodegradable filter made from wood pulp, but they also consist of 100% natural African tobacco without artificial additives, wrapped in chlorine-free paper,” said company founder and c.e.o., Adam van Wyngaarden.

The eco-conscious theme also extends to Woodland’s packaging. Unlike other packaging, the brand’s inner liner is made from degradable, metal-free, and non-toxic paper. The outer box consists of recycled, unbleached and unlaminated cardboard that is sourced sustainably; and even the box printing is accomplished solely with food-grade soy inks. Van Wyngaarden asserted that Smokey Treats is “the only independent craft cigarette manufacturer in the southern hemisphere.”

Woodland is currently sold in more than 1,000 stores across South Africa and also has begun exporting to foreign markets, seeking to develop further strategic partnerships with interested importers and distributors “to help the brand grow internationally.”

Since its launch, Woodland has “successfully replaced over two and a half million plastic butts with biodegradable ones,” according to van Wyngaarden. As an additional commitment to the environment, 1% of all net profits from Woodland sales are donated to planting trees and food gardens around South Africa.

TISA - An Influential Club

The Tobacco Institute of Southern Africa (TISA) operates as a voluntary trade association representing tobacco farmers, leaf merchants, leaf processors, manufacturers, and tobacco product importers and exporters active in the region. The institute is jointly funded by its members, who currently comprise:

  • Alliance One International
  • British American Tobacco South Africa (Pty) Ltd
  • Clippa Sales South Africa
  • Imperial Tobacco Southern Africa
  • JT International South Africa (Pty) Ltd
  • Limpopo Tobacco Processors (Pty) Ltd
  • OTP Distributors (Pty) Ltd
  • Philip Morris South Africa (Pty) Ltd
  • Tobacco Traders CC
  • Universal Leaf South Africa (Pty) Ltd

TISA’s main focus area is to ensure the sustainability of the legal tobacco sector in South Africa and the Southern African Customs Union (SACU, comprising Botswana, Eswatini, Lesotho, Namibia, and South Africa). To achieve this, TISA is involved in, amongst other tasks:

  • Participating in legislative processes to assist in achieving balanced and evidence-based regulation and taxation of the tobacco sector.
  • Combatting and reducing the illegal cigarette trade, for example by commissioning independent external research to measure size and impact of the illicit cigarette trade in South Africa and working with government and law enforcement authorities in public and/or private partnerships to combat the scourge.
  • Setting leaf research objectives in consultation with a specialist research committee to assist tobacco farmers to increase quality and yield of their produce and thereby remaining sustainable.
  • Supporting the principle of harm reduction with TISA members committed to working towards furthering the development of harm reduction products.