Times continue to be tough for tobacco players in the midst of changing cigarette prices, burgeoning taxes, and Ministry’s tough love on the nation to reduce smoking.
The Pakatan Harapan government is seen keeping its promises post election. To recap, in its Alternative Budget 2018, Pakatan Harapan outlined the curbing of illicit cigarettes to drive the largest indirect tax gains under its governance – crucial for sustaining its fiscal position subsequent to the reinstatement of the Sales and Services Tax.
Post-election, key figures including Finance and Deputy Finance Minister, as well as Director-General of Royal Malaysian Customs were reported to have singled out concerns on the illicit trade and plugging tax leakages, beckoning the significance of the illicit incidence to Pakatan’s immediate priorities.
This led to the decision for the retail price for all cigarette brands to be increased in two weeks’ time.
Health Minister Datuk Seri Dr Dzulkefly Ahmad said the prices of tobacco products including cigarettes had to be increased due to an increase in taxes under Regulation 8A of the Tobacco Revenue Control Regulations 2004.
“The recent implementation of the Sales and Services Tax (SST) will cause the prices for all types of tobacco products including cigarettes, to be increased,” he told a press conference at the Parliament lobby last week.
This comes as the “tax holiday” during July and August 2018 saw heightened spending from consumers, which further encouraged merchants and outlets capitalising on the event with “GST-free marketing”.
In September 2018, the new Sales and Services Tax (SST) system became effective but raised much uncertainty with its implementation, causing some manufacturers to withhold any resulting price increase from the tax.
“This was also seen amongst certain tobacco players who retracted their SST-due price increases. Eventually, the translated price hikes could abate consumer spending and skew performances, as consumers rushed to capture lower product prices as soon as possible,” said Kenanga Research in its consumer report last month.
“Tobacco players will continue to see mounting pressures from the difficulty in adjusting prices to levels more favourable to consumers.
“Illegal tobacco products, which make up about 63 per cent of Malaysia’s total industry volume – could potentially see further expansion from the widening price gap against the legal brands.”
While government channels appear to be working towards more aggressive enforcement to clamp down on the illicit market, Kenanga Research said its effectiveness could still pose a question mark as previous efforts had not produced materially positive results.
“While sin stocks may still command fair dividend yields of about four per cent, the potential capital downside should raise cautions to yield-seeking investors,” it added.
Fiscal consequences to the PH government
All these tax changes on the tobacco sector will without doubt have its fiscal consequences to the newly minted Pakatan Harapan government.
According to the Asia Illicit Tobacco Indicator 2017: Malaysia report by Oxford Economics, Malaysia applies a single-rate, unit-specific excise tax rate of RM400 per 1,000 cigarettes following an Excise Tax hike implemented in November 2015.
Prior to this, a mixed excise tax system was in operation which included both a specific rate equal to RM280 per 1,000 cigarettes, and an ad valorem rate of 20 per cent of the ex-factory price.
A General Sales Tax of six per cent was applied to cigarettes in 2017, in common with other goods and services, after Malaysia introduced a universal rate in April 2015.
According to the Oxford Economics report released in July 2018, actual revenues from tobacco consumption were estimated to have increased by 10.9 per cent to RM4 billion in 2017. Actual revenues from tobacco consumption have now increased for two consecutive years.
“The estimated tax loss associated with illicit consumption was RM4.7 billion in 2017, rising by 10.6 per cent in comparison to 2016, underpinned by an increase in the volume of illicit consumption over the same period,” it said.
“The Excise Tax Loss as a share of total potential excise tax revenues remained at 51.6 per cent in 2017, unchanged from 2016.”
Looking ahead, the Budget 2019 announcement on November 2 is expected to yield positive developments on the illicit trade incidence.
The research team at Affin Hwang Investment Bank Bhd (AffinHwang Capital) expects this to include a proclamation of action on the war against illicits as well as a rain-check on raising excise duties this year while the government concentrates on enforcement efforts to shore up its sin tax collections.
“We believe expediting the ITP’s adoption will also be a promising show of commitment by the Pakatan administration to undertake serious actions against the illicit market, given the empirically-backed control measures dictated by the program as well as co-operative advantages with regional parties on tracking and curbing the smuggling network.
“On the other hand, we also keep a lookout for further news on the Health Ministry’s proposed smoking ban at open-air eateries, which could have a lasting impact on consumers’ smoking habits.”
BAT staying upbeat on its revival
As the only listed tobacco player in the country, all eyes are on British American Tobacco (Malaysia) Bhd (BAT Malaysia) as it maneouvres its way around all the new changes in the industry – on the back of current challenges.
On Monday, BAT unveiled its profits for the third quarter of its financial year 2018 (3QFY18), with normalised net profit coming in at RM145.8 million. This led to 9MFY18 normalised earnings of RM352.2 million, which is broadly within consensus’ full-year FY18 earnings estimates at 76 per cent.
As its three-year price hike hiatus ended, Affin Hwang Investment Bank Bhd (AffinHwang Capital) opined that a reversion of a cigarette hike could stay on.
“As reported, BAT rolled back its price hike – prices of its Premium/Aspirational Premium/VFM brands which were recently raised by RM0.50/pack – as it awaits regulatory approval on the price changes, while seeking further clarity from authorities on appropriate treatment of the differential between the 10 per cent sales tax and the six per cent GST.
“This comes after Philip Morris maintained that its RM0.20 hike was not prompted by any absorption of the SST, which is forbidden by law. Subsequently however, Deputy Minister of Domestic Trade, Chong Chieng Jen asserted that tobacco players were not compelled to pass on SST costs by any legal stipulations.
“We hence hold onto a zero-hike assumption for BAT, while expecting the matter to be resolved soon alongside budding price discrepancies seen in the market.”
BAT, alongside industry players JTI and Philip Morris, has always operated under a heavily regulated industry environment, with tax-driven price hikes – 10 duty/15 price hikes over the last 15 years – being regular occurrences in the past.
“So, the recent hike is merely a normal industry recurrence,” AffinHwang Capital affirmed. “Historically, price hikes have had a commensurable negative impact on cigarette volumes.
“JTI and Philip Morris’ hikes of RM0.20 to RM0.50 per pack are in stark contrast to the previous spate of hikes which saw a pack of premium cigarettes skyrocket 42 per cent from RM12 to RM17 over FY13 to FY15.
“In addition, we do not anticipate the illicit cigarettes market to exacerbate further, as we have previously remarked that taxes and price hikes have not been indicative of the illicit trade in the past. Rather, it is more of a structural issue linked to enforcement efforts by the authorities.”
In any event, should there be a price hike, AffinHwang Capital believed the impact on BAT would be minimal as in the past, BAT has been able to pass on tax hikes, with price revisions outpacing that of excise duties, in order to make up for the anticipated fall in cigarette volumes.
“BAT’s profitability was sustained in the years when the illicit trade’s aggravation was contained. Incidentally, the illicit trade has plateaued at 63 per cent of the market since 4Q17.
“We sense that the worst has already came to pass from the illicits’ perspective, and thus the impact of future ASP hikes on volume sales will once again be governed by inelasticity dynamics for cigarettes.”
In a separate note, Kenanga Investment Bank Bhd (Kenanga Research) believed thicker smoke was ahead as we await the Ministry of Health unveiling the official guidelines on the rate of increase in the coming weeks.
“Management does not discount the possibility that the proposed hike could be greater than the earlier rise of 50 sen per pack.
“In the meantime, the group will absorb any differences in taxes until the resolution of the matter. We believe the higher margin enjoyed during the 3-months “tax holiday” could provide enough support to buffer the potential losses from this tax for the year.
“Regardless, it is possible that the industry may see another distortion to monthly sales number with another round of forward buying in October at the expense of November and December sales.
“It is likely the illicit cigarettes levels will persist at current peak levels and further down-trading to VFM products could undermine future results to come.
“Post-results, we leave our assumptions unchanged for now, awaiting statements on the formalised price increase per pack.”
Illicit market continues to rise
A worrying concern is that a hike in tobacco prices could see more consumers switching to illicit cigarettes.
AllianceDBS Research believes that without strict enforcement, a price increase in tobacco could lead consumers to trade down to illicit cigarettes.
It said the introduction of the higher Sales and Service Tax could impact earnings for cigarette manufacturers, which would require the government to intensify efforts to curb smuggling of illegal cigarettes.
“Given that illicit trade remains high at 63 per cent market share, we believe that another price hike would further widen the gap between prices of legal and illegal cigarettes,” it said in its note.
“Consumers’ affordability will be affected and they might down trade to much cheaper products.”
AllianceDBS said 3QFY18 was an expectedly positive quarter as the company benefited from the Goods and Services Tax holiday.
However, given some confusion over prices following the introduction of the SST, the tobacco industry is requesting for more clarity and guidance from the Ministry of Health, which is now set to announce a new price structure next month.
To this, MIDF Amanah Investment Bank Bhd (MIDF Research) noted that illicit cigarettes market remains at all time high of 63 per cent. The dip in BAT’s revenue and, thus, earnings year-over-year was mainly attributable to the lower domestic and duty-free volumes which slumped by 5.8 per cent year-on-year.
The lower domestic volume was mainly impacted by the legal market volume which contracted by minus 3.8 per cent year to date in comparison to 3QFY17.
Additionally, the illicit cigarettes volume share remains stagnant at a record high of 63 per cent since 1QFY18 which consists of smuggled cigarettes at 59 per cent and quasi legal cigarettes with fake tax stamps at four per cent.
This, in return, has impacted the group’s volume, translating to a decline by eight per cent quarter-on-quarter in terms of the group’s overall volume sold.
The Asia Illicit Tobacco Indicator 2017: Malaysia by Oxford Economics released in July 2018 showed growth in illicit consumption in 2017, marking the second consecutive year that illicit inflows have risen in Malaysia.
The 10.7 per cent increase in total illicit Inflows was underpinned by a rise in consumption of Contraband whites – such as John, Saat, and U2 – which rose by a further 15.6 per cent in 2017, after posting growth of 48.2 per cent in 2016.
Overall, Contraband whites accounted for an estimated 46.6 per cent of total consumption in 2017, increasing by 4.5 percentage points from 2016.
Within this, smuggled whites – white cigarettes produced by a non-domestic manufacturer identified with Contraband features — remained the dominant component, accounting for nearly 90 per cent of total Contraband whites, equivalent to an estimated 7.8 billion cigarettes.
A relatively new phenomenon, which first emerged in 2016, of Contraband whites known as “Quasi Legal” cigarettes, consisting of local brands with fake tax stamps, rose in prominence in 2017. Such Quasi Legal cigarette brands identified in the Empty Pack Surveys included 9th Century, Manchester, and A380.
Estimates derived from the Empty Pack Surveys suggest that they represented 5.7 per cent of Total Consumption in 2017, more than double the equivalent share of 2.8 per cent observed in 2016.
The overall rise in Contraband whites more than offset a decline of 9.2 per cent in consumption of Contraband or smuggled kreteks in 2017.
On peninsular Malaysia, the highest levels of Illicit Incidence were found in the central and east coast states of Kelantan, Pahang, and Terengganu, where Illicit Consumption in each accounted for around three-quarters of Total Consumption.
Sabah and Sarawak in East Malaysia also displayed high levels of Illicit Incidence, above the national average (69.3 per cent and 76.2 per cent respectively).
Industry driven by health-based initiatives
Malaysia is playing its part towards a healthier Malaysia. The country is one of the early signatories who acceded to the World Health Organisation’s (WHO) Framework Convention on Tobacco Control (FCTC), which compels parties to advance activity on controlling tobacco usage through price and non-price measures, including a minimum recommended taxation-to-retail-price ratio of 65 per cent imposed on tobacco products.
Malaysia’s ratio stood at 53 per cent in 2016, signifying room for higher duty charges necessitated to meet FCTC’s guidelines.
“Hence, we anticipate further duty hikes to follow suit over the coming years,” AffinHwang Capital explained.
“That said, we believe tobacco players can withstand the hikes so long as the illicit incidence is curbed in due course, as demand inelasticity should persist due to a lack of serious smoking alternatives disrupting the local industry.”
“On the other hand, the recent motion to ban smoking at open-air restaurants constitutes one of the WHO’s non-price measures to protect people from tobacco smoke.
“Looking ahead, we expect the Health Ministry to also fulfil the remaining MPOWER measures, such as implementation of plain packaging laws.
“The implication from global studies performed is that tobacco volumes will continue to fall on a secular trend as a result of these anti-smoking policies.”
Despite that, most of the non-price initiatives have already been implemented if not raised for consideration, leaving limited surprises on that front, in AffinHwang Capital’s view.
Illicit trade renders FCTC implementation ineffective
As guided by the WHO, the proliferation of illicit cigarettes in the market undermines the effectiveness of raising tobacco taxes and gaining incremental revenues from tobacco products.
“Therefore, the curbing of the illicit trade is a prerequisite towards achieving the desired outcomes through price-based control measures, lest a lose-lose-lose situation beckons for the government, the public as well as the legal tobacco players, as smoking rates prevail while the un-taxed black market thrives,” the research firm added.
“Hence, we assess the government’s priority with addressing the illicit trade pandemic to stem from billions in annual tax leakages amidst a tightening fiscal position, as well as high prevalent smoking rates in Malaysia given the easy accessibility to cheap, un-regulated cigarettes offered rampantly throughout convenience stores in the country.”
Meanwhile, regional efforts on illicit trade proved successful.
“Taking a leaf out of the regional book from countries that have resolved to and successfully tackled the illicit problem in their jurisdictions, we reiterate our view that combating the illicit trade is not a tall order, so long as adequate resources and concerted efforts are invested into the cause.
“Despite becoming party to the FCTC earlier on, Malaysia has surprisingly failed to ratify the WHO’s Protocol to Eliminate Illicit Trade in Tobacco Products (ITP) conceived in 2012 and kicking into force, signalling an absence of focus in recent years to undertake meaningful measures to combat the illicit trade,” it explained.
A 2015 paper by the Economics of Tobacco Control Project showed that Malaysia was a notable laggard behind its illicit-afflicted peers in adopting similar control measures.
In comparison, studies have shown considerable success with tackling the illicit trade over a short matter of time through a combination of interventions adopted by governments prioritising on the illicit trade.
“With the illicit trade at an all-time and (also embarrassingly) the world’s highest rate of 63 per cent, the Pakatan Harapan government cannot afford to overlook the issue any further under its administration, not solely for its multi-billion tax leakages but also for the inefficacy of curbing smoking prevalence in the country, as long as the illicit trade remains unaddressed.”
Adopt clear strategies to handle illicit trade
The new government remains committed in its manifesto to taking concrete action to reduce illicit trade in Malaysia, which damages legitimate business, causes social harm and deprives the government of much needed revenue.
On this point, IDEAS published a Policy Ideas titled: “Combatting Illicit Trade: Lessons from Abroad”.
The report proposes a series of practical recommendations to help combat illicit trade based on experiences from other countries around the world.
As Budget 2019 approaches, the report released on Wednesday this week urges the government to adopt a new tougher strategy to reduce illicit trade. Illicit trade is not a problem unique to Malaysia.
Many countries around the world have sought to tackle the smuggling of contraband and the spread of counterfeit goods by adopting better technology, stricter penalties and educating the public, among other initiatives.
Commenting on the release of the report, IDEAS chief executive officer Ali Salman, it is crucial that the government step up its efforts to counter illicit trade, which is draining the government of much needed revenue and harms legitimate business.
“The government should follow the example of other countries and establish a clear strategy, governed at the highest levels to tackle this problem,” he said in a statement.
“There are also number of the specific steps the government should take, including increasing penalties and improving cooperation with the private sector.
“Illicit tobacco in particular remains a major problem and the government should hold back from any further increase in prices and review the existing tax structure as well as tightening enforcement on known smuggling routes.”
1. Adopt a new cross-government strategy, with clear political ownership.
Efforts to tackle illicit trade have been sporadic and led by individual agencies. The government should set out a new, overarching illicit trade strategy to implement the promises of Buku Harapan. A new Illicit Trade Task Force should be established, chaired by the Minister of Finance with participation from these agencies to oversee implementation of the strategy and ensure all agencies contribute.
2. Formalise cooperation with the private sector.
Under the strategy, cooperation with the Private Sector should be improved through the formation of a new Trade Enforcement Committee with membership from government agencies and industry to share information, consult on new policies and support operations. This cooperation should include establishing a customs recordal mechanism.
Set specific targets for seizures and publish data on performance. The government should adopt specific targets for seizures in line with the scale of the problem to ensure consistent and proactive effort by the different agencies. The government should publish systematic annual statistics on seizures and penalties, so that the public is able to gauge the overall trends in illicit trade and hold the government accountable for its efforts to reduce it.
3. Review policies on enforcement staff across different agencies to put the right incentives in place and reduce the scope for corruption.
There are a series of steps the government should consider as part of an overall process of improving incentives and reducing the scope for corruption: introduce performance based pay, with rewards linked to high value seizures; automate all processes where possible; introduce a clear sanctions process; and introduce staff rotation in high-risk positions.
4. Do not further increase excise duties on tobacco, and consider a review of the current tax regime.
Multiple tax hikes on cigarettes have led to a drastic increase in the legal price of cigarettes and this has led to stark increases in the illicit trade in tobacco.
The government should not raise the price any further and instead review the existing taxation regime in light of experience in other countries, such as Canada and Pakistan, that have successfully reduced illicit cigarette trade after reforming excise duties.
5. Ban the sale of duty free cigarettes at Langkawi, Labuan and Tioman.
The previous government had admitted that the tax free islands were a source for illicit tobacco, but previous proposal to ban sales of duty free tobacco had failed in favour of restrictions. The government should now ban the sale of duty-free cigarettes, but this can be done on a time limited basis to be reinstated once enforcement capacities have been improved.
7. Proceed quickly with plans to increase penalties to RM100,000.
The current levels of penalties to do not act as a sufficient deterrent and need to be increased in line with the proposals from Royal Malaysian Customs.
6. Introduce bank guarantee scheme for transhipments.
A major route for illicit products is transhipments – the government should require transhipments to place a bank guarantee until delivery at final destination can be confirmed. In order to reduce the impact on legitimate trade, this should be conducted on a risk based approach, targeting only high risk products, and operators with good track records excluded.
8. Consider restricting access for certain imports to a single point of entry.
Under this measure, imports of those products which are identified as high risk should only be allowable at a single point of entry into the country.
So that enforcement resources can be focussed on this point, and imports of these products arriving at other points can be seized as a matter of routine, simplifying the process at these points. This new policy should only be used for very specific products, such as tobacco, subject to high risk of illicit trade.
9. Launch public education campaigns.
The government should focus on raising public awareness on the personal health risk associated with consuming illicit products and the fact that the proceeds of illicit trade can be used to fund more harmful criminal activity.
Source: Borneo Post Online