No Way Back for South Africa’s Legal Tobacco Market?

Eighteen months after lifting its cigarette ban, South Africa still struggles with inflated illicit sales, proving that the experts were right when they said the ban would entrench illicit trade into the day-to-day life of the country and make it very difficult to eradicate, reports Stefanie Rossel of Tobacco Reporter.

The situation is not helped by the fact that measuring illicit trade in South Africa is even more difficult than elsewhere, given that it doesn’t use security features or tax stamps on cigarettes. And while the major legal cigarette manufacturers in the country have called on the South African Revenue Service (SARS) and law enforcement agencies to increase their efforts to prevent criminal networks from selling illicit cigarettes, little has been done so far.

In May 2020, SARS cancelled a tender for a track and trace system. ‘One of the main challenges was the lack of consultation with the industry, as local manufacturers and wholesalers would have been required to implement the system and bear the cost of implementation,’ said Ahmad Ismail, General Manager for Southern Africa at Japan Tobacco International.

‘Another challenge was that South Africa did not ratify the Framework Convention on Tobacco Control (FCTC) Protocol on Illicit Trade (ITP) and that the tender was not in line with the FCTC approach. This would have enabled them to align the system with global guidelines and systems being implemented and allocate a budget dedicated to fully comply with the protocol guidelines following a recommended and tested process implemented in Europe,’ he added.

In 2020, SARS instructed all cigarette manufacturers to install production counters that reported directly to the authorities how many cigarettes were coming off the production line in real time. But, according to Johnny Moloto, General Manager at BAT South Africa (BATSA), this measure was not enforced. In any case, advised Ismail, while being a step in the right direction, the system still relied on the transparency of manufacturers to report on their production levels.

Illicit trade doubles up

According to the market leader BATSA, before the ban, illicit trade already accounted for approximately 33% of all cigarettes sold in the country.

‘With very weak enforcement by government during the ban, the legal industry adhered 100% to the ban, but it gave the illegal players a golden opportunity to take over 100% of the market during that time,’ explained Francois Van der Merwe, advisor to the South Africa Tobacco Transformation Alliance.

One and a half years after the ban was lifted, illicit tobacco still claims an estimated 60% of the total market, one of the highest shares in the world and only comparable to Malaysia. Out of a total market of more than 32 billion sticks, only 12-13 billion cigarettes were tax-paid in 2021, according to Van der Merwe.

An online survey by the University of Cape Town’s Research Unit on the Economics of Excisable Products (REEP) showed that 90% of smokers continued to purchase cigarettes during the lockdown. Unable to buy their pre-lockdown brand, 46% of smokers switched from a multinational company brand to a brand produced by a local producer.

Most of these licensed companies are members of the Free-Trade Independent Tobacco Association. Critics contend they conducted illegal business by selling vast quantities of their products at a fraction of the minimum collectible tax of ZAR 21.60 ($1.41) per pack of 20 – sometimes for as little as ZAR 6 per pack.

According to BATSA, these companies manufacture and earn profit on vast volumes of cigarettes while paying the South African Revenue Services (SARS) only a small portion of the tax owed.

BATSA estimates that this under- declaration costs the country’s treasury at least ZAR 8 billion ($546 million) annually. For the 2021-22 government fiscal year, this figure is expected to rise to ZAR 21 billion. BATSA reckons that more than 90% of all illegal cigarettes in South Africa are manufactured locally.

During the lockdown, illicit whites (legally produced cigarettes destinated primarily or exclusively for illicit distribution, outside the jurisdiction in which they were produced) were freely available, although at hugely inflated prices. The temporary sales prohibition dramatically changed the purchasing environment, the REEP survey found.

Before the lockdown, 56% of smokers bought their cigarettes from formal retailers, but only 3% did so after the ban had been lifted. The percentage of smokers who purchased from small informal spaza shops in townships increased significantly.

Street vendors, friends and family or ‘essential workers’ became new sources of cigarette supply. The profitability of dealing with illicit cigarettes attracted a range of new players, including crime syndicates, but also civilians seeking to make a living amid a worsening economic crisis.

The financial damage of the ban was immense: it cost the government ZAR 5.8 billion in tobacco tax revenue from BAT alone. In addition, the government lost a court case filed by the tobacco industry regarding the constitutionality of the ban. BATSA said it lost more than ZAR 2 billion due to the sales ban.

While alcohol sales largely recovered after restrictions were relaxed, legal cigarette sales continued to languish. ‘The fiscus is projected to lose ZAR 19 billion in cigarette excise tax in the 2021-22 fiscal year alone as a result, which the country cannot afford,’ said Moloto.

In November last year, global market research group Ipsos found that illegal cigarettes were available in almost half of stores (43%) nationwide. Cigarettes are selling for the equivalent of ZAR 8 per pack, close to a third of the ZAR 21.60 in tax that should have been paid. ‘It is clear that taxes on these products could not have been paid by the manufacturer,’ said Moloto.

Given the lack of security features or tax stamps, the Ipsos study used the ‘mystery shopper’ model, under which researchers bought the cheapest cigarettes in almost 5,000 stores nationwide. Its findings echo those of the REEP survey. The ban, it said, would feed an illicit market that ‘will be increasingly difficult to eradicate when the lockdown and COVID-19 crisis is over’.

Ahmad Ismail believes South Africa has now reached that point. ‘The legal industry declined by over 40% alone during the COVID-19 tobacco ban,’ he said. ‘Illicit tobacco flourished with very little enforcement during the lockdown. We have also witnessed an increase in cross-border smuggling in and out of South Africa, which was a problem that we had not experienced in several years. It will take more than three years for the legal industry to recover – not fully – if government acts immediately.’ 

‘The failure of government to enforce its own regulations during the sales ban was a golden opportunity for illicit operators to establish their brands firmly in the market in the absence of the legal brands,’ said Van der Merwe. ‘By dropping their prices post the lifting of the ban, they simply retained their market share, and the legal tax- paying brands are struggling to regain lost market share.’

At an annual tax conference in 2021, the SARS Commissioner noted that the lockdown brought about a proliferation of illicit cigarettes that has now embedded itself as an alternative to regular brands. He said SARS was fighting a losing battle in this regard.

Government must act now

Moloto said the South African government must act to stop the flow of illicit cigarettes before the problem becomes even more entrenched. Both BATSA and JTI have asked the government to ratify the ITP immediately.

‘South Africa has been a founding member of the FCTC where the former Minister of Health, Honorable Dr Aaron Motsoaledi, signed the ITP in Geneva in January 2013,’ said Ismail. ‘Putting in place a track and trace system would allow tobacco products to be traced from the manufacturer to the wholesaler and to retail and contribute to the reduction of massive illegal cigarette trade.’

JTI believes that a full digital volume verification system, in combination with a track and trace system, would be the most effective and affordable migration. This would give the government real-time insight into what is manufactured and thus help it curb under-declaration and tax evasion.

‘Track and trace aimed at tracking cigarettes from manufacturing plants to point of sale on its own will not prevent illicit trade,’ Ismail admitted. ‘However, it will support law enforcement agencies and legitimate businesses working in collaboration to reduce the problem.

Consistent audits by the SARS need to continue, seizures of illegal tobacco products must intensify, and law enforcement agencies need to work in a coordinated manner to increase prosecution or closures of operators that decide to conduct illegal practices.’

In addition to the other measures, BATSA has called for a minimum legal retail price of ZAR 28 per pack. ‘This is a simple way to allow the police to seize illegal cigarettes more effectively without having to prove that the manufacturer has not paid the taxes due,’ said Moloto. ‘It could be implemented quickly through the declaration by the government of a minimum price for cigarettes. It would also help consumers to differentiate between legal and illegal products.’