APPENDIX
Government response
Recommendation 1.
Excise duty fraud grew significantly during the
1990s partly as a result of the opportunities provided to criminals
by the introduction of the single market and of the large increases
in international trade and passenger movements. We note Customs'
acknowledgement that they did not initially react with sufficient
speed to these developments. We are concerned that Customs failed
to recognise and react to the effect that these events, which
were predictable, would have on the level of smuggling and fraud.
But we welcome the more strategic response which has subsequently
been put in place.
The Government notes the Committee's concerns. The
wider backdrop to the growth in excise fraud was the introduction
of the Single Market but other factors played their part, most
notably the reducing investment in Customs and the introduction
of the tobacco duty rate escalator. Between 1990 and 1997 there
were reductions of over 3,500 Customs staff and in the same timeframe
the tobacco duty rate escalator ensured there were occasions when
cigarette prices increased dramatically in short periods of time.
For example, in 1995 there were two increases with a combined
effect of over 12%.
In 1997, the Government cancelled a previously planned
further reduction of 300 staff and subsequently, in 2000, as part
of the Tackling Tobacco Smuggling strategy, provided HM Revenue
& Customs with an extra £209 million to fund almost 1000
additional HM RC officers and a national fleet of x-ray scanners.
This marked the start of a fundamental change in the Department's
approach to tackling fraud by moving from a tactical approach
to one based on well researched operational strategies delivering
unambiguous outcomes, including additional funding for HM RC to
tackle oils and alcohol fraud.
The Government has also set HM RC challenging year
on year targets under its Public Service Agreement (PSA) to reduce
the illicit market share of smuggled cigarettes. The target for
2007-08 is to reduce the illicit market share to 13%.
Recommendation 2.
While the differential in excise duty rates between
the UK and other countries may be a significant factor in the
level of legitimate cross-border shopping, most smuggling and
fraud involves products on which little or no duty has been paid.
Customs accepted that there was a relationship between rates of
duty and the level of fraud. We would welcome a published study
of this relationship.
The Government agrees that most smuggling and fraud
involves product on which little or no duty has been paid, with
large scale commercial smuggling continuing to account for the
vast majority of seizures. In 2003-04, 76% of all cigarette seizures
were commercial consignments intercepted either overseas or at
UK seaports. As HM Revenue & Customs continues to successfully
restrict the availability to smugglers of genuine product, so
those smugglers are increasingly looking to counterfeit sources
for their contraband. In 2003-04 54% of seized cigarettes were
counterfeit, compared to 15% in 2001-02. These counterfeit cigarettes
are manufactured in illegal factories in China, the Far East,
Russia and Eastern Europe and then smuggled into the EU. Spirits
fraud involves the illegal diversion of alcohol on which no duty
has been paid, irrespective of the country of origin. Oils fraud
involves the misuse in the road fuels sector of domestically sourced
fuels that carry a significantly lower rate of duty for off road
uses such as heating. This is also a significant part of the
problem in Northern Ireland, but the land boundary here means
that there is also smuggling of both rebated fuels and road fuels
from the Republic of Ireland.
In relation to tobacco, analysts at HM
Revenue & Customs and academics at the London School of Economics
have recently developed a new theoretical model of this market,
which aims to capture its modern complexities. The model has been
published as a Government Economics Service paper titled 'The
Demand for Tobacco Products in the UK', and is available on the
HMRC website at www.hmrc.gov.uk.
Recommendation 3.
We support the approach now adopted by Customs
that efforts to tackle fraud must be based on an accurate assessment
of the size and nature of the problem. We acknowledge that estimating
the level of excise duty fraud is difficult. Although useful progress
has been made, we are concerned that losses from smuggling and
fraud are currently estimated to be some £3,750 million a
year, and therefore remain at an unacceptable level.
The Government welcomes the Committee's support.
HM Revenue & Customs are in the forefront of the European
Union in measuring excise evasion, and have been producing estimates
of the amounts evaded from excise duties for several years; we
first published a complete set of estimates of losses in tobacco,
spirits and oils in November 2001 (for 1999-2000). The strategic
approach adopted by HMRC has seen the volume of cigarettes smuggled
cut by a third, oils fraud down by a quarter and spirits fraud
substantially reduced.
Despite this success, the Government has set challenging
targets to reduce smuggling and fraud further, so that by April
2008 the illicit market share for cigarettes is no more than 13%,
the illicit market share for spirits has been reduced to at least
half, and the illicit market share for oils in England, Scotland
and Wales is no more than 2%.
Recommendation 4.
Customs and the tobacco industry broadly agree
on the scale of cigarette smuggling, that it peaked in 2001 at
around 21% of the market, and that it is now declining. Customs'
strategy for tackling tobacco smuggling appears to be having an
effect on illicit cigarettes, but with revenue losses running
at £1,900 million a year, there is still a long way to go.
Through their Tackling Tobacco
Smuggling strategy, announced in March
2000, HM Revenue & Customs have succeeded first in halting
the previous rapid growth in cigarette smuggling and then reducing
the market share for illicit cigarettes to its current level of
15 per cent. In the past four years more than 9 billion cigarettes
have been seized and over 259 gangs involved in large scale smuggling
broken up. Furthermore, the total number of cigarettes smuggled
into the UK each year has been reduced by over 5 billion sticks,
which represents a reduction of over one third.
Although tobacco smuggling is now being contained,
the Government agrees that there is still much work to do. That
is why the target set by the Tackling Tobacco Smuggling
strategy has been extended to reduce the illicit market to 13%
by 2007-08.
Recommendation 5.
The fact that only 3 out of every 10 packets of
hand rolling tobacco consumed in the UK are duty paid is a matter
of very serious concern. The illicit market share for hand rolling
tobacco has been above 50% of the market for each year since estimates
have been available, and is now rising. In our view this indicates
that the level of smuggling in this area is extraordinarily high.
We note that the Treasury and Customs are considering what action
to take to provide a fresh focus on hand rolling tobacco in their
strategy for tackling tobacco smuggling. Effective action is urgently
required.
The Government agrees that the illicit market share
for hand rolling tobacco (HRT) is cause for concern. The respective
markets for cigarettes and HRT are evolving differently with the
proportion of smokers who smoke HRT having increased against a
backdrop of decreasing overall consumption. Analysis undertaken
by HM Revenue & Customs has identified that the proportion
of smokers who smoke HRT has more than doubled from 10% in 1992-93
to 22% in 2002-03. The respective illicit markets are also fundamentally
different with the majority of illicit HRT being sourced, duty
paid, in the EU.
As the Chancellor announced in the Budget, the Government
is considering further action to tackle the smuggling of hand-rolling
tobacco with a view to announcing a package of further measures
later in 2005.
Recommendation 6.
Customs have signed memoranda of understanding
with the major UK tobacco manufacturers designed to reinforce
co-operation in tackling tobacco smuggling into the UK. We expect
tobacco manufacturers to co-operate fully with Customs to ensure
that their products do not get into the hands of smugglers. We
note the views of both Customs and the UK manufacturers that the
current arrangements are working well and that this is evidenced
by a reduction in the amount of genuine UK- manufactured cigarettes
in the illicit market.
The Government welcomes the Committee's recognition
of the impact of the work undertaken with the tobacco manufacturers.
HM Revenue & Customs expect this co-operation to continue
and are looking to enhance the existing Memoranda of Understanding
to ensure greater control of legitimate supply chains and introduce
further measures to address the problem of counterfeit.
Recommendation 7.
The memoranda of understanding between Customs
and the UK manufacturers predate the EU agreement with Philip
Morris. However, answers we received to questions asking what
difference the memoranda had made to what was being done before
did not leave us with an impression of a radical change in the
practices of the major UK tobacco companies. We recommend that
Customs review the provisions of each memorandum in the light
of the commitments contained in the EU agreement with Philip Morris
with a view to reinforcing the existing arrangements where necessary.
The Government agrees with this recommendation.
HM Revenue & Customs are reviewing the provisions of the memoranda
of understanding they have and aim to conclude any revised arrangements
this year. HM Revenue & Customs work with the Tobacco Manufacturers
has seen the incidence of UK manufactured cigarettes being smuggled
back into the UK fall markedly from about 75% of large seizures
in 2000-01 to 28% in 2003-04.
Recommendation 8.
We are concerned to note, particularly in view
of the claimed success of the memoranda of understanding with
UK manufacturers, that Customs have not sought a similar agreement
with Philip Morris. The UK could have signed, and still can sign,
the EU agreement with Philip Morris with the prospect of receiving
payments from the company when their tobacco products are seized
as contraband. Had this been done, payments would have been due
to the UK for smuggled Philip Morris cigarettes in 2003-04. Whether
it would be better for the UK to sign the EU agreement or to seek
a separate memorandum of understanding with Philip Morris depends
upon the arrangements that can be negotiated with the company.
But doing nothing is unacceptable. We expect Customs to take this
matter forward as a matter of urgency.
HM Revenue & Customs will reconsider the need
for a specific memorandum of understanding (MoU) with Philip Morris
International (PMI) in light of the other MoU reviews that are
currently underway. HMRC do not currently have an MoU with PMI
as their products have very little significance in the illicit
UK tobacco market. In 2003-04 less than four in every 100 cigarettes
seized were genuine PMI product; Customs estimate that the supplementary
payments to the UK in 2003/2004 for smuggled PMI cigarettes would
have been well under £1 million. In the same year PMI branded
cigarettes equated to 3.5% of total UK seizures compared with
2.6% in 2002-03. Indications for 2004-05 are that the proportion
of genuine PMI product seized has fallen below 2002-03 levels.
On the basis of market share alone, it is questionable
whether there are sufficient benefits to warrant co-signing the
PMI Agreement with the EU. Not only does PMI product make up
a tiny share of the illicit market in the UK but their deal with
the EU is inferior in some respects to the agreements HMRC currently
have in place with the other tobacco manufacturers. For example,
the tracking and tracing provisions to identify a first customer
are only applicable to master cases (10,000 sticks), whereas both
Imperial and Gallaher are able to trace the first customer from
a single pack of 20 sticks. Nor does the EU-PMI deal cover the
intra-EU illicit cigarette trade.
Recommendation 9.
Counterfeit cigarettes are a significant and growing
problem in the UK that threaten both revenues and public health.
We note Customs' efforts and those of the industry to tackle this
issue which, to be successful, depend on co-operation with enforcement
agencies overseas to identify contraband destined for the UK and
to cut off the supply of counterfeit cigarettes at source, the
illegal factories where they are made.
The Government agrees with this conclusion. Following
the introduction of the Tobacco Strategy, HM Revenue & Customs
have been increasingly active abroad, employing 15 Fiscal Liaison
Officers (FLOs), who are permanently based overseas, within a
network covering 44 countries. In 2003-04, this overseas network
intercepted more smuggled cigarettes before they reached the UK
than were seized at UK seaports.
HMRC have increased the resources invested in the
Fiscal Liaison Officer (FLO) network, and will continue to review
these resources ensuring they remain appropriate to target the
levels of perceived risk.
Recommendation 10.
We were surprised to learn during our visit to
China, the largest source of counterfeit cigarettes destined for
the UK, that there was only one UK Customs officer, based in Hong
Kong, to cover the whole country. We were also surprised to discover
that until our visit there had been no meetings between UK Customs
and the State Tobacco Monopoly Administration, the agency charged
with tackling cigarette counterfeiting in China. We recommend
that Customs review the resources they are devoting to intelligence
gathering and co-operation with enforcement agencies overseas
and the location of the officers concerned and consider placing
officers within China.
The Government agrees with this recommendation.
In 2001-02 counterfeit cigarettes were a relatively small problem
in the UK with HM Revenue & Customs estimating that 15% of
large seizures were counterfeit. This proportion has grown steadily,
so that in 2003-04 counterfeit cigarettes had grown to 54% of
all seizures. HMRC believe that the primary sources of counterfeit
cigarettes are currently China, the Far East, Russia and Eastern
Europe.
In view of this growth in counterfeit cigarettes,
HMRC, having reviewed the resources devoted to liaison work in
China, appointed an additional officer from April 2005 and are
currently seeking to fill a further post which will increase the
complement in the region to three. It is likely that these officers
will continue to be based in Hong Kong which is conveniently situated
for the main export locations of counterfeit cigarettes, and liaison
with Chinese Customs, at the maritime ports in Fujian, Guangdong,
Zhejiang and Shanghai Provinces.
HMRC aim to address the supply of counterfeit product
from China by working through the most appropriate channels to
achieve this. HMRC are party to the existing Inter Governmental
Multi-Agency MoU which allows them to co-operate with the Chinese
law enforcement authorities in combating criminal activity. China
Customs, who come partly under the Ministry of Public Security
are included in this, whereas the State Tobacco Monopoly Administration
(STMA) are not. Furthermore, the focus of the STMA is on inland
activity—dismantling factories and packing houses etc, and
UK Customs cannot assist them in this as they have no intelligence
on this activity.
The work HMRC has undertaken with the Chinese authorities
has resulted in some notable successes. For example, in 2004
more than 23 million counterfeit cigarettes have been seized in
China in joint operations between UK and China Customs. The relationship
HMRC have with the Chinese authorities is productive and they
continue to work to improve it.
Recommendation 11.
We recognise that estimating the level of spirits
revenue evaded through fraud and smuggling is difficult. But confidence
in Customs' estimates of spirits fraud is undermined by a number
of factors. The figures are disputed by the industry, whose alternative
estimate, showing fraud to be much lower, is equally valid statistically.
The level of uncertainty attached to Customs' estimates is such
that their latest figure for fraud, of £250 million a year,
falls statistically within a range of minus £150 million
to plus £650 million. And if the methodology used for estimating
spirits fraud is applied to beer, it produces a result that suggests
more tax is collected than beer is consumed.
Recommendation 12.
Given these factors, we conclude that specific
estimates for spirits fraud can only be viewed with caution. We
look to the review being undertaken by the Office for National
Statistics to result in more accurate estimates being produced.
We expect this to be completed and published promptly.
The Government partially accepts the committee's
conclusion and has always acknowledged that there is an inherent
level of uncertainty in the published spirits fraud estimate.
However, the Government is satisfied that the current estimate
- for 2002-03 is reasonable and notes that HM Revenue & Customs
operational evidence suggests that spirits fraud is a significant
problem. For example, that year HMRC seizures prevented over 100,000
bottles of illicit spirits finding their way onto retail shelves
every month (1.3 million bottles seized in the year) and they
successfully prosecuted 55 people for alcohol fraud offences,
in doing so disrupting 24 criminal gangs involved in the supply
of non-duty paid alcohol.
The Government welcomes the Office for National Statistics
decision to review consumption data sources and awaits their report
with interest.
Recommendation 13.
Excise duty receipts on beer, wine and other alcohol
products were some £5 billion in 2003-04, substantially more
than the £2.4 billion collected on spirits. We note Customs'
evidence that the level of fraud is much lower in this area, but
it is of concern that there are no reliable estimates to support
this view. We look to Customs to provide robust estimates of the
level of fraud in all areas where significant revenue streams
are at risk.
The Government accepts the Committee's concern.
HM Revenue & Customs continue to explore alternative methods
to measure the illicit beer and wine markets, however this is
a technically demanding undertaking.
Tax gap estimates are based upon estimates of total
consumption from survey data, which contain significant levels
of statistical uncertainty. Results from spirits show that currently
available datasets from the Office for National Statistics produce
ranges in the estimate of around plus or minus ten percentage
points for alcohol consumption. This makes it difficult to measure
any fraud activity of less than 5 to 10 per cent, which is believed
to be the case for wine and beer. Solving this and the statistical
challenge of correcting for underreporting of consumption of these
products relies on obtaining new, more accurate, estimates of
total consumption.
Work in this area is ongoing and is a priority, but
may require the commissioning of a specific survey, which will
take some time to produce results. In the short term HM RC is
developing a risk matrix for alcohol that will inform operational
activity and future strategy development. It will be in use from
the autumn 2005 and, coupled with operational results analysis,
will enhance the department's capability to identify criminal
activity and trends in fraud, including beer and wine.
Recommendation 14.
The Government is convinced that tax stamps on
spirits bottles are required to tackle alcohol fraud. Following
lengthy and detailed consultations with industry, which have resulted
in a number of changes to the proposals to minimise compliance
costs, a tax stamp scheme is to be implemented early in 2006-07.
The decision to proceed with the scheme was made when losses were
estimated to be some £600 million a year. But estimated losses
have fallen, without a tax stamp regime being in place, to £250
million a year, a figure which on past experience could well be
revised downwards.
Recommendation 15.
The decision to implement tax stamps should be
based on accurate and up-to-date assessments of the level of fraud,
and of compliance costs, in order to determine whether the expected
benefits outweigh the costs. Customs' estimates of fraud contain
a significant level of uncertainty, and the most recent figure
is for the year 2002-03. We expect this estimate to be revised
as new information is available, either from later figures, or
as a result of the review being undertaken by the Office for National
Statistics. But as the latest estimate of fraud (£250 million
a year) is of a different order of magnitude from the estimated
compliance costs (£7 million start-up costs and £5 million
a year thereafter), we conclude that the latest proposals for
tax stamps cannot be considered a disproportionate response to
the problem.
The Government accepts the Committee's conclusion.
Since the intention to introduce duty stamps for spirits was announced,
the Government and HM Revenue & Customs have worked extensively,
and very constructively with the industry to ensure the development
of a scheme that will be effective in helping to reduce spirits
fraud, but that also minimises and offsets the compliance costs
to the legitimate trade.
Recommendation 16.
We received little evidence on oils fraud during
our inquiry. Customs' estimates of the level of fraud do not appear
to be a matter of dispute with the industry, but we are concerned
that proper figures for Northern Ireland are not available.
HM Revenue & Customs do not have figures for
the illicit market in Northern Ireland as we are unable to collect
data on cross-border shopping. Unlike the major entry and exit
points from Great Britain, traffic is not canalised when it crosses
the Northern Ireland land boundary, instead it passes through
one of around 300 crossing points. This means it is not possible
to make reliable estimates of cross-border shopping or smuggling
and therefore HM Revenue & Customs publishes a non-UK duty
paid market share figure, which covers both fraud and legitimate
cross-border shopping.
These estimates, published in the Pre-Budget Report
in 2004, show that the revenue loss in the non-UK duty-paid market
in Northern Ireland road fuel has reduced by 9% between 2000 and
2003. Moreover, the Industry have long used the deliveries of
legitimate road fuel into Northern Ireland as a measure of the
health of the market. Following five years of decline between
1996 and 2000, we have seen three years of successive increase
in 2001, 2002 and 2003 as shown in the following table.
| Diesel | Petrol
| Total | +/- |
| 2000 | 190m litres |
405 m litres | 595 m litres |
-13% |
| 2001 | 205 m litres |
430 m litres | 635 m litres |
+7% |
| 2002 | 245 m litres |
450 m litres | 695 m litres |
+9% |
| 2003 | 290 m litres |
450 m litres | 740 m litres |
+6% |
Recommendation 17.
We note Customs' evidence that oil frauds in Great
Britain are principally the result of rebated fuels fraud—the
laundering, mixing and misuse of red diesel, kerosene, and oils
used for industrial processes. We are concerned at the scale of
fraud in this area, currently estimated to be some £850 million
a year, and we are struck by the fact that there has been a consistent
pattern of estimates for a given year being subsequently revised
upward. We cannot consider Customs' strategy for tackling oils
fraud to be working satisfactorily when losses continue at this
level. We therefore recommend that this strategy and the resources
devoted to tackling oils fraud be reviewed if there is not a significant
improvement when the next figures are produced with the Pre-Budget
Report 2005.
The latest estimates of diesel fraud show that it
is reducing with the illicit market reduced from 8% at the end
of 2000 to 6% at the end of 2003. Based on operational data HM
Revenue & Customs expect to see a further reduction in the
GB illicit diesel market when our estimates for 2004 are published.
However, if the expected reduction in the illicit market in 2004
does not occur, then we accept the Committee's recommendation
that it would be necessary to carry out a review of the UK Oils
Strategy.
HM Treasury
17 June 2005
| 
