There are lots of questions, but few answers, for "brick & mortar" retailers assessing the threat of online tobacco sales.

By Joseph Finora

There's a general feeling that we probably ought to try to address this issue," said Sen. Greg Server (R-IN), chairman of the Senate Commerce and Consumer Affairs Committee when asked by the Evansville Courier & Press about tax-collection and age-verification concerns for tobacco products sold over the Internet. The Senator's plainly spoken comments basically summarize the current state of this messy wrinkle in tobacco retailing. Lawmakers, policy pundits, free-trade advocates, entrepreneurs, and tobacco groups across the country are searching for answers to one of the thorniest issues to hit the industry: traditional tobacco retailers vs. Internet retailers or "e-tailers."

Consumers are increasingly turning to the Internet to buy tobacco products to save money - in most cases, that means beating soaring taxes. And since many tobacconists - and all tobacco outlets - also sell cigarettes, that can add up to a double-dose of lost sales. If a customer comes in to buy some Macanudos for himself, he may also take a carton of Virginia Slims for his wife. You'll lose all these sales when he shops on-line because lottery tickets and newspapers are available at the gasoline station and supermarket. Convenience and in-depth product selection are distant factors.

Which isn't to say there aren't disadvantages to shopping over the Internet. For consumers, on-line negatives include time spent waiting for the purchase to arrive and shipping charges. And the price advantage is largely contingent on the commonplace practice of avoiding tax responsibility.

When someone buys tobacco products from an e-tailer located in one state, he or she is responsible for paying that state's tobacco excise stamp. If you are a resident of the state, you will also pay applicable sales tax. More often than not, the purchaser is outside the state - and usually in a high-tax state. When someone buys tobacco products online, they are technically making a purchase in the state (or Indian Reservation) where the e-tailer resides. Therefore, the purchaser pays all applicable taxes in effect for that location. In theory, when the customer pays his annual income taxes, he's supposed to report all out-of-state purchases and pay all locally applicable taxes. This applies to any products - books, clothing etc. In reality this has rarely been the case, but more recently budget-pressed states have begun to closely scrutinize the lost revenues which, in the case of tobacco products, is considerable. Plus, given the anti-tobacco sentiment nationwide, states are taking notice to see who has reliable age-control verification. This issue is anything but clear-cut. First, a Reality Check At the close of 2002, Internet sales accounted for 2% of industry volume and should hit nearly 6% come 2005, according to Prudential Financial, which also identified 120 "sites" competing with you 24 hours a day, seven days a week. A Camel 10-pack sells for less than $40 on one site, compared with more than $60 in a convenience store. Web-based tobacco sales could reach $5 billion by 2005, costing states $1.4 billion in tax revenue annually, according to an analysis by Forrester Research Inc. The price difference is largely due to the absence of taxes for the e-tailer. If you have trouble believing this, you probably also think computers are "just a fad."

The Jenkins Act requires any person who sells and ships cigarettes across a state line to a buyer, other than a licensed distributor, to report the sales to the buyer's state tobacco tax administrator. According to Philip Morris USA, Inc. research, some sites report sales, others won't say whether they do or not. A few note privacy concerns for not reporting such information. Some Native American shippers argue that they're sovereign nations and are exempt. According to the same report, officials in nine states said they are limited in what they can accomplish in their efforts to be sure e-tailers are complying with the Jenkins Act.

Since January 2002, about 20 states have increased cigarette excise taxes by an average of 39 cents per pack, hiking the national average to 60 cents per pack. Prudential also estimates that e-tailers earn about $1.29 per premium cigarette carton and a little better than $5 per carton for bargain brands. "Super bargain brands" can be found on-line for as little as $10 per carton. Since they know the Internet shopper is often looking to save money, they're generally good prospects for the lower-tier brands.

High tax stamps cause a lot of other ill effects on brick-and-mortar retailers, according to Patrick Carroll, founder of recently launched Freedom Tobacco (www.freedomtobacco.com), manufacturer of Colombian-made Legal brand cigarettes and a former British American Tobacco executive.

"Most smokers also buy candy, gum, drinks, etc. with their purchase," says Carroll. "Now with the Internet, that doesn't happen." He also notes a few other basic problems in the retailer vs. e-tailer battle, such as an increase in organized crime. "Since New York [City] raised its taxes," argues Carroll, "it's seen an increase from something like five cases of smuggling to over 250." Last year, New York State raised its cigarette excise tax from $1.11 to $1.50 per pack, while New York City raised its own cigarette tax from 8 cents per pack to $1.50, sending retail cigarette prices there soaring to about $7 per pack. On a more practical side, Carroll adds, "The on-line guys have two big disadvantages. It's not an instant purchase (buy and get at the same time), and then there's a shipping charge or the customer has to drive a long distance to pick up the package."

And it's not just in the big cities. Last year, Indiana raised its per-pack tax on cigarettes to 55 cents from 15.5 cents, sending some buyers across the Ohio River to Kentucky, where the tax has remained at 3 cents a pack - one of the nation's lowest. "We're afraid this is costing Indiana a lot of money," said John Keeler, a lobbyist for Philip Morris USA. "We'd just like to make sure jurisdictions, including Indiana, are getting every penny they're entitled to." Many e-tailers noted an increase in orders from New York City residents shortly after it invoked its latest excise tax increase, according to the Prudential report. Interestingly, all of New York City is surrounded by lower-tax jurisdictions.

But whenever a government imposes a system, individuals try to beat it. Intrepid entrepreneurs from the Northeast are driving to low-tax states like South Carolina and returning with a trunk filled with cigarettes for sale. Some are sold to retailers; others are sold on the street directly to passersby for cash - again robbing municipalities of revenue. And then there's the problem of inventory costs. The more valuable something is, the more expensive it is to insure and the more likely people want to steal it - digging an even a deeper hole for retailers.

In cyberspace, maintaining a deep inventory isn't as much a problem. "Many retailers hold fewer brands and styles of brands," continues Carroll. "So if you're a Legal smoker, you'll have a hard time finding my product locally as we don't sell as many as Marlboro. But if you want Marlboro Light 100's in a box, well you might have to settle for Marlboro Light King box. Thus another reason to buy on-line. They've got more brands available."

Huge tobacco taxes create a "Prohibition-like" mentality, argues the Manhattan Libertarian Party, which notes that a similar tax in Canada (1992-93) was repealed after two years because of the $1 billion smuggling industry it spawned. Since Indiana increased its excise tax, state tobacco tax revenue has fallen about 5 percent below projections.

In August the U.S. General Accounting Office reported that most online retailers do not comply with the federal Jenkins Act. Indiana Department of Revenue's tax policy administrator, Tom Conley, said the state can - and sometimes does - collect taxes from online buyers. Law-enforcement officials, namely from the Bureau of Alcohol, Tobacco and Firearms (BATF), are inheriting more responsibility from the Federal Bureau of Investigation (FBI) to apprehend tobacco smugglers as the Feds are more concerned with fighting terrorism.

Outlook: Challenges Ahead
Selling tobacco products to underage smokers remains a big issue for e-tailers. While the local tobacconist selling mostly pipes and cigars generally isn't hassled by the underage crowd and can easily and effectively check for identification, the e-tailer has very little defense. While credit cards are not issued to anyone under 18, that alone is not an adequate defense. Only United Parcel Service provides age verification among shippers. Several Internet sites, including those of many cigar manufacturers and retailers, do not inquire about age verification. Some issue a warning to visitors before entering the site or post ineffective requests such as, "Click here if of legal age." Others do not attempt to address the issue at all. While a few states have sued e-tailers for selling to minors, the age verification issue is probably not enough to put e-tailers out of business.

The Online Tobacco Retailers Association (www.oltra.org) says it is working to make sure minors can't obtain tobacco products through the Internet. OLTRA was formed in 2001 by "concerned online tobacco retailers" to address consumer protection and quality assurance issues. Several major online retailers are represented. Its board of directors includes leading e-tailers: eSmokes.com, dirtcheapcig.com, and Senecasmokeshop.com among others.

If Internet sales continue to grow at the expense of retailers and municipalities, state lawmakers - according to everyone interviewed for this article - may be forced to reconsider lowering their taxes as the increases would backfire, causing revenues to drop and smuggling, counterfeiting and other illegal practices to grow. Suits are being considered against several e-tailers over tax-compliance issues.

Many are asking Congress for a bill to require Web-based companies to verify that buyers are not minors and would force shipping companies to check a purchaser's age again at delivery. Most e-tailers mail packages through a common carrier such as the post office, where there are little or no regulations to determine the age of buyers. Other e-tailers, however, will call the phone number provided in the order and often require a fax of age verification, such as a driver's license.

Traditional tobacco retailers should not be shy about leveraging their advantages as responsible corporate and social citizens. Let your Representative know the amount of tax your business pays and how many people you employ (payroll tax), that you're a good-citizen and conduct airtight age-verification practices. Start a petition in your store, asking customers to sign. Politicians often take notice when lots of voters are involved. Let your legislators know that an e-tailer in another state threatens to reduce your state's tax role and increase unemployment - a double-hit - while possibly putting more tobacco in the hands of minors. Then let them know that all of this is in danger of "going up in smoke" thanks to e-tailers and that if the tobacco tax was lowered, the playing field would be a little bit closer to level.

SMOKESHOP - June, 2003