March 1 (Bloomberg) -- A dozen tobacco companies have gained from a legal loophole that helped them avoid as much as $1.1 billion in U.S. taxes.
Their secret: Using fillers such as the clay found in cat litter or stuffing the products with more tobacco to tip the scales in their favor. The heavier weight let the companies sidestep a 2,653 percent increase in a federal excise tax, taking advantage of a 2009 law that spared so-called big cigars.
There were 22 companies producing small cigars in the year before the law created the new tax structure, according to data from the Treasury Department’s Alcohol and Tobacco Tax and Trade Bureau. Twelve of those companies, none of which the government would name, either switched to or increased production of large cigars in the year following the law, the bureau found.
“It shows what length the tobacco companies will go to avoid taxes and regulation that were designed to improve public health without regard to their customers,” Danny McGoldrick, vice president of research at the Campaign for Tobacco Free Kids in Washington, said in a telephone interview. “They should equalize the tax to stop the shenanigans.”
The practice has contributed to a doubling in sales of the weightier tobacco products and slowed a decade-long decline in tobacco use. The Centers for Disease Control and Prevention in an Aug. 2 report blamed sharp increases in adult consumption of pipe tobacco and cigarette-like cigars since 2008 on the 2009 law “that created tax disparities between product types.”
The Government Accountability Office estimated in an April report that “market shifts from roll-your-own to pipe tobacco and from small to large cigars reduced federal revenue by a range of” $615 million to $1.1 billion from April 2009 through September 2011.
U.S. Senator Dick Durbin, an Illinois Democrat, introduced legislation Jan. 31 to close the loophole. The bill would equalize the tax structure so there wouldn’t be an incentive to manipulate products, generating $3.6 billion in new tax revenue over 10 years, Christina Mulka, a spokeswoman, said by e-mail.
The loophole appears to have mainly benefited smaller tobacco companies. Reynolds American Inc., the second-biggest U.S. tobacco company, doesn’t operate in that market, David Howard, a spokesman for the Winston Salem, North Carolina-based company, said in an e-mail.
Altria Group Inc., the largest seller of tobacco in the U.S., said its John Middleton Co. unit had already been selling large cigars with its Black & Mild line before the change in the law. The company didn’t have to make any shifts in how it formulates the cigars, which mostly are wood or plastic tipped and come as singles or in packs of two or five, David Sylvia, a spokesman for Richmond, Virginia-based Altria, said by phone.
Prime Time International Co., a closely held tobacco company, sells some of its large cigars and flavored cigars in 20-count packs, similar to regular cigarettes. Closely held Cheyenne International LLC, based in Grover, North Carolina, also specializes in smaller-sized cigars that have a similar look and design of cigarettes.
Jack Wertheim, chairman of Phoenix-based Prime Time, said shifts into the “large” cigar market are about responding to customer demands. The company sells large and small cigars to satisfy customers who prioritize taste and quality and appease those who want a lower-priced product, he said.
Prime Time isn’t saving on taxes, and any savings would be passed to the customer, Wertheim said.
Current rules require a rolled tobacco product to weigh at least 3 pounds per 1,000 to be labeled as a “large” or “premium” cigar, a category where taxes increased just 155 percent.
The Treasury Department said tobacco companies aren’t doing anything illegal by making their products heavier.
“If you meet the definition of a large cigar, then you’re a large cigar,” Thomas Hogue, a spokesman for the tobacco bureau, said in a telephone interview. “There’s nothing in the Internal Revenue code that goes after the specifics on how that weight is achieved.”
Hogue wouldn’t provide the names of the tobacco makers switching to heavier products.
Cheyenne was found to make two kinds of cigars that look like cigarettes yet weigh enough to be taxed as big cigars. One of the two has a regular fiber filter; the other has filters made of white fiber cylinders surrounding a granular clay substance.
Jim Pankow, a chemistry professor at Portland State University in Oregon, published the first measurements of how addictive nicotine is when delivered by tobacco smoke. He agreed to conduct X-ray diffraction tests on the weightier Cheyenne product on behalf of Bloomberg News and found the clay filters were made of sepiolite. The weighty mineral is used for absorption in waste treatment, industrial cleaners and pet litters, according to the European Industrial Minerals Association.
“They’re making products that are classified as cigars that are designed almost exactly like cigarettes,” Pankow said in a telephone interview.
The vast majority of Cheyenne’s cigars that are considered large began marketing in 2007, said Marc Scheineson, a partner at Alston & Bird LLP in Washington who is regulatory counsel for the tobacco company. He didn’t say when the company’s heavyweights hit shelves. He said less than 3 percent of the company’s sales come from little cigars and heavyweights.
The Alcohol and Tobacco Tax and Trade Bureau reviewed Cheyenne’s products to determine which excise class they fit in, he said.
“You can look at this as a loophole or tax planning or a way to perpetuate job growth or small business continuity,” Scheineson said in a telephone interview.
British American Tobacco Plc’s Kent cigarettes used a similar micronite filter at one point. The London-based company said it moved the cigarettes to charcoal filters long ago.
“The decision regarding whether to use charcoal or micronite filters is simply down to taste and currently, charcoal filters are used in Kent cigarettes in the vast majority of international markets where the product is sold,” Will Hill, a spokesman for the company, said in an e-mail.
Filtrona Plc, a maker of cigarette and cigar filters, said its sepiolite-based Cavitec Flavour product is one of many specialty filter types. Altogether they represent about 17 percent of the Milton Keynes, U.K.-based company’s total filter sales globally, Melanie Hulbert, a spokeswoman, said in an e-mail. Filtrona wouldn’t reveal its customers’ names, citing confidentiality agreements.
In addition to avoiding some taxes, cigars also sidestep a ban on flavored cigarettes. Cheyenne’s heavyweight products come in wild cherry flavor, while their other cigars can be bought in flavors such as grape and vanilla.
The result is that while cigarette smoking -- the leading preventable cause of death in the U.S. -- continued an 11-year downward trend, large cigar smoking tripled from 2000 to 2011 and loose tobacco pipe smoking has jumped almost sixfold, the CDC said last year in a report.
Sales of large cigars more than doubled to 1 billion units a month in September 2011, from 411 million when the law took effect in January 2009, the GAO said. At the same time, small cigar sales dropped to 60 million from 430 million.
The FDA, which was given the authority by Congress in 2009 to regulate tobacco, primarily cigarettes, is now looking to broaden its rules.
The agency is “moving as expeditiously as possible to release for public comment a proposed rule to regulate additional categories of tobacco products,” Jennifer Haliski, an agency spokeswoman, said in an e-mail.
The FDA is scheduled to release a proposed rule by April, the federal Office of Management and Budget, which oversees all regulation development, said on its website.
To contact the reporter on this story: Anna Edney in Washington at firstname.lastname@example.org