Online Tobacco Sales Ignite Fight Over Taxes
SAN FRANCISCO - The ideal product to sell online would be easy to pack and ship, be much cheaper than what's charged at the retail counter, and be craved by tens of millions of people every day.
Cigarettes, the Internet was made for you.
As tobacco has come under ever-heavier pressure in the off-line world, with massive lawsuits, bans in offices and restaurants, an increasing social stigma, and a spiraling price per pack, the Internet has offered a refuge. Here Marlboros and Camels can be acquired without encountering the surgeon general's warning or a request for an ID. Best of all, the price is about 30 percent lower than in the local supermarket.
No wonder hundreds of cigarette Web sites have sprung up in the past year, with some of the proprietors ambitiously estimating that the online world will eventually gain as much as 20 percent of the $50 billion U.S. tobacco business.
But tobacco's glory days on the Internet may be ending almost as soon as they began. California and Washington state are using an obscure law to get cigarette sites to hand over the names and addresses of customers, who are then dunned for excise and use taxes. Wisconsin is setting up sting operations against online retailers. And in New York, a new law effectively outlaws Internet sales of cigarettes to individuals.
"This is definitely not typical for e-commerce," said Jeff Graham, an entrepreneur who is unfazed enough to be launching Smokestore.com in October. "But if states and the federal government are making it difficult for smokers off-line, which they are, it shouldn't be surprising that they're also making it tough online."
Tougher, in fact. The Internet is generally a tax-free zone, where retailers are deliberately shielded by Congress from the task of collecting duty. It's also a place that has been largely self-regulated, where few states have the expertise or the will to get involved. Local merchants might complain that they are at a disadvantage against their Web competitors, but they rarely get official support.
Tobacco reverses those dynamics. Part of the impetus for the current regulatory actions comes from sliding sales of cigarettes at bricks-and-mortar retail outlets, usually right after local taxes are raised.
California, for instance, boosted its excise tax from 37 cents to 87 cents per pack on Jan. 1, 1999. Over the next three months, sales of cigarettes fell 34.7 percent from the previous year. Some smokers may have quit, but authorities suspected that others started purchasing through unregulated means, buying cigarettes from bootleggers or over the Internet.
Another regulatory spark was complaints by parents, who were upset that it was so easy for kids to order cigarettes online. "A lot of people then started looking," said M. Carter Mitchell, the Washington state official in charge of tobacco tax enforcement. "They saw it was not a local problem, a regional problem, but a national issue."
Much of the Internet cigarette market is shrouded in vagueness. Many of the sites are run from Indian reservations, which are free to set their own retail regulations, but some are not. Analysts say they have no idea of the size of the total market or even what the biggest companies are. "You get the feeling many of these are fly-by-night," said Preston Dodd, an analyst with Jupiter Communications, a research firm specializing in Internet commerce.
Gary Kirschner, the founder of Cigarettesbymail.com, has been the most visible executive in this young industry and possibly one of the most successful. Formerly with Brown & Williamson Tobacco Corp. and its parent, British American Tobacco PLC, Kirschner told one publication that his site's revenue doubled every week for the first eight weeks.
Kirschner professes little concern about the regulatory efforts to snuff out his business. "There are no statutes that regulate what we're doing," he said. "California is using a law that in our opinion doesn't even apply to what's going on today."
Before the Internet, smokers who made the voyage to either Indian reservations or stores in tobacco-growing states got a bargain. If they brought back more than two cartons, technically they had to pay an excise tax in their own states. But as Dennis Maciel, chief of the excise tax division of the California Board of Equalization, puts it: "Realistically, how were we going to know?"
The Internet changed that. It put tax-free cigarettes within the reach of anyone with a computer, and it also created a record of sales. So the Board of Equalization did a little computer research and fired off a letter to about 100 Web sites, pointing out that under the provisions of a 50-year-old federal law called the Jenkins Act they were legally bound to file monthly reports to the state.
Originally designed to stop the shipments of cigarettes to anyone other than a licensed distributor, the Jenkins Act requires shippers to list the name and address of any recipients of cigarettes, as well as the brand and quantity they bought.
The Indian sites responded that they were located in sovereign nations and were not subject to the Jenkins Act. Other sites, such as Cigarettesbymail.com, simply refused to provide lists. But a few sites coughed up names and addresses.
Last year, the California tax authorities began writing those delinquent citizens, asking for an excise tax payment of $8.70 a carton--even if they had bought as little as one carton. This year the state also started billing for a use tax, which is essentially a replacement for the traditional sales tax the smokers would have paid had they bought the cigarettes in a store.
The use tax in California varies by county but averages about 7.5 cents on each dollar. Technically, everyone who buys goods from an out-of-state Internet company should be paying a use tax. In practice, hardly anyone does.
The letters caused a good deal of surprise and some consternation. "When we sent out 3,000 tax returns, it's a safe estimate we received 3,000 phone calls asking 'What is this about?' " said tax administrator Maciel.
Many of those who were dunned by California readily paid up. Through the first quarter of this year, 4,946 citizens were billed, and more than 78 percent have settled their accounts.
"Most people just want to pay and move on," Maciel said. "It's an educational experience for them." More are already being educated: The program more than doubled in size in the second quarter.
In Wisconsin, meanwhile, attempts to enforce the Jenkins Act are just getting started. It's a poor weapon--the penalty for lawbreaking businesses is a misdemeanor charge and a maximum fine of $1,000--but it's the only one the state Department of Revenue has.
"Until someone at the federal level takes an interest in this, I don't really think we're going to get anywhere," said Jim Jenkins, the state's chief of alcohol and tobacco enforcement.
So he's trying to force the issue by ordering from tobacco sites. When the shipments are received, the regulators will file a request for the addresses of all the customers in the state. If they don't receive it, they plan to inform federal prosecutors of the noncompliance.
New York has decided on a different approach. On March 1, New York raised its tax on cigarettes from 56 cents a pack to $1.11. Sales fell 22 percent by June. In a law signed by Gov. George E. Pataki (R) earlier this month, shipments of cigarettes in the state must be made to a licensed dealer. Internet, mail and telephone orders sent directly to consumers are banned by the measure, which goes into effect Jan. 1.
Enforcement of the law will focus on Web sites and any common carrier such as Federal Express or United Parcel Service that transports tobacco to state residents, said Marc Carey, a spokesman for the state Department of Taxation and Finance.
Many of the Indian sites that sell cigarettes to New Yorkers and everyone else are located in upstate New York. "I imagine there's going to be a legal challenge to this," said Duane Ray, president of the Seneca Nation. Even if there isn't, "we don't quite understand how the governor's going to be enforcing this."
UPS, too, seems a little unsure. "There is an obligation by New York state to make sure the enforcement of the law is feasible," said Tad Segal, a spokesman for the carrier. At the moment, he added, "it's too early to say" whether it is.
One possible scenario is that those shipping cigarettes to New Yorkers start using the U.S. Postal Service, over which the state has no jurisdiction. "That has the potential to be somewhat of a loophole," spokesman Carey conceded.
To smoking rights activists, the new law--which officials in other states say will be closely watched and inevitably copied if it is successful--is further evidence of unwarranted persecution.
"The Internet is being used to speed up the criminalization of smoking for adults," said one such activist, Wanda Hamilton. "It makes it so much easier to track and identify smokers. I find it all frightening."
Serenia Bodie, a 62-year-old retired caretaker in Tumwater, Wash., knows all about how the Internet can get smokers in trouble. After seeing an advertising circular for an Internet cigarette company in her local newspaper early last year, she started ordering. In three months, she bought 530 packs for herself and her children, also smokers.
Last August, Bodie received a bill from the state for $437.25 in taxes due. Living on Social Security payments of $649 a month, she couldn't imagine paying it--and, after contacting the cigarette site, was mistakenly told she didn't have to.
In November, Bodie got a new bill. This time it had a $10-a-pack penalty. Her bill ballooned to $5,745.38. "I don't know what I'm going to do if I have to pay this," she said. "I keep hoping they've forgotten, but I know better."
The demand had another result. "This is the greatest deterrent I've ever had in my life," Bodie said. After 46 years, she's quit smoking.