How the sin tax policy created a duopoly

MANILA, Philippines - The cigarette industry in the country has long been a showcase of how political economy works in the Philippines. While businessman Lucio Tan has been generally perceived to have perfected the art of influencing regulation and tax schemes to favor his Fortune Tobaco Corp., the expansion efforts of multinational player Philip Morris in the Philippines has changed the playing field.

As Philip Morris announced on Thursday a deal that involved the acquisition of majority stakes in Fortune Tobacco, the shifts in the local playing field on cigarette products is sealed.

The shift—from monopoly to a duopoly—has been gradual. The road to the February 25 announcement of the deal took a little over 8 years.

When Philip Morris set its eyes on the Philippine market as one of its growth areas in Asia in 2002, it quickly learned how the game is played. It has since successfully carved out a significant share from Fortune’s previous firm grip on over 80% of the market.

While the multinational firm has the world’s best practices on marketing a deadly product at its fingertips—it operates in over 160 countries—one aspect of the business was key: sin taxes.

Rising Fortune

When Lucio Tan, a non-smoker, set up Fortune Tobacco in 1965 with meager funds, his closeness with then President Ferdinand Marcos became a necessary tool for generous tax and import incentives. These propelled his cigarette brands to gain a step ahead of other popular local and foreign brands in the Philippines.

As Marcos’ favorite in the “sin” businesses—tobacco and alcohol—Tan’s cigarette firm had a near monopoly for decades. His businesses thrived even after Marcos was toppled in 1986.

Tan and Fortune Tobacco faced tax evasion cases for allegedly manipulating the computation of excise taxes based on the selling price of cigarettes that leave its factory. A 7-level distribution chain made up of dummy marketing companies reduced the taxes it paid. Some of these numerous tax cases remain pending in court while a few have been shelved.

Some of his companies, including Fortune Tobacco, have also pending cases filed by the Presidential Commission on Good Government, the government unit charged to go after illegal wealth acquired during the Marcos administration.

Through all these post-Marcos cases, Fortune continued to thrive and even landed on the top 10 largest cigarette companies in the world in the late 1990’s. Global industry watchers considered the Philippines as one of the markets that seemed impossible to penetrate.

Small players, like La Suerte Cigar and Cigarette Co, Sterling Tobacco Corp, and Anglo American settled for the crumbs. To have a presence in the Philippine market, global players settled with licensing agreements: Philip Morris with La Suerte and Sterling with an Indonesian firm.

One of Fortune’s first and main money-spinners was budget brand, Hope. Eventually, global firms, like RJ Reynolds, also inked a license for the manufacture and sale of its global brands: cigarette-store.biz/online/winston, cigarette-store.biz/online/camel, Salem, and others. When RJ Reynolds had legal and financial troubles in the US, RJ Reynolds sold its brands to Fortune. Japan Tobacco eventually acquired the firm.

Fortune’ success was partly due to its wide portfolio of cigarette brands that cover almost all pricing points from premium to low-priced cigarettes. It also has a nationwide distribution reach, which is key to retail products that have to make it through hundreds of islands.

Philip Morris had to deal with these challenges when it decided to add Philippines in its international portfolio.

Global player, local market

Philip Morris International, the non-US arm of one of the world’s biggest cigarette players, has been peddling its global brand, Marlboro, in the Philippines since 1955. At the time, however, business in the US was still booming, so it simply inked a licensing deal with local firm La Suerte. (Read: Philip Morris and its Philippine saga)

Then the barrage of bad press, coupled with strict legislation on advertising, market targeting, and the imposition of higher taxes came. Philip Morris, just like other global brands, decided to cast their net elsewhere. The populous Asia was on their radar. Philippines was included in the list of target markets.

The Philippines, where some 84 billion sticks are consumed in a day, is the second biggest market in Asia, next to Indonesia where there are over 50 million smokers. According to research firm Datamonitor, the market for tobacco products in the Philippines increased at a compounded annual growth rate of 4.9% between 2003 and 2008.

Philip Morris ended its 47-long relationship with La Suerte in 2002. The Switzerland-based multinational established Philip Morris Philippines Manufacturing Inc (PMPMI) as its local arm, a signal that it was upping the ante by taking full control of its operations here.

It was the beginning of what would eventually become a full-blast battle between the local and global giants.

The multinational firm knows how to play the game. By 2003, it opened a P1.6 billion factory in Batangas with no less than President Arroyo inaugurating it. She lauded it for being a testament of investor confidence in her administration. By January 2010, PMPMI broke ground on its P1-billion-worth facility in Subic in Central Luzon. Officials claimed it was proof of their claim that the US Naval Base-turned-freeport-zone is a viable a logistics hub in Asia.

Taxing the sin

For being an early player in the game, Fortune already has an edge over Philip Morris in terms of favorable excise tax schemes imposed on its products.

A complex tax code based on 1997 prices created generally favorable pricing schemes for Fortune. Its brands, Salem and Camel, were classified as locally manufactured and therefore belonged to the low-price category, subject to the lowest tax rates.

In other countries, Salem competes directly against Winston and Pall Mall. Winston, another brand carried by Fortune, became a mid-priced brand with a higher levy.

For PMPMI, the code resulted in discrepancies. While its global brand, Marlboro, is a premium brand in almost all its markets outside the Philippines, Philip Morris 100’s, which is classified as mid-to low-priced brand in other countries, was regarded as a premium brand here, thus was subject to higher tax rates.

PMPMI, still learning the ropes then, tried but failed to reverse the code.

Meantime, PMPMI’s former partner, La Suerte, saw the tax scheme as an opportunity. The current tax code then was obviously favoring locally manufactured cigarette brands of Fortune. La Suerte also has its homegrown brands, Memphis (sold mainly in Luzon) and Astro (available mainly in Visayas and Mindanao), which belong to the lowest segment.

La Suerte played aggressively, gaining a significant sales share for itself in 2002 and continuing to attract consumers throughout 2003 with ridiculously low prices.

PMPMI, realizing that it has no products that can compete head-on with Fortunes’ and La Suerte’s low-priced brands, acquired 4 low-priced brands under Sterling Corp which has a licensing agreement with an Indonesian partner. (Philip Morris’ Indonesian unit acquired a stake in the Indonesian cigarette maker.)

In 2003, PMPMI also introduced L&M, the second most popular brand in the world, to plug the gap in its portfolio for mid-priced brands.

By 2004, the tide turned against La Suerte. The government, pressed for efforts to improve its revenue base, implemented a 4-tiered complicated sin tax system that involved bi-annual increases in tax rates from 2005 to 2011.

The complex tax code levied rates based on the net retail price per cigarette pack. It also favored “old” brands (those introduced to the local market before 1996) over those that were sold starting 1997. “New” brands could be reclassified but the “old” brands could stay in their bracket.

The changes in the tax system hit La Suerte twice. Its low-end brands, Astro and Memphis, which were introduced to the market in late 1990’s, were re-classified as mid-priced brands. This meant that, while their previous competitor brands in the low-priced bracket are shouldering only P2.47 per pack in 2009 and P2.72 in 2011, their new classification as mid-priced brands resulted in taxes of P7.14 and P7.56, respectively.

The jump of La Suerte’s own brands’ tax burden to almost 3 times that of the low-priced brands of both Fortune and PMPMI led to its slow death.

Pall Mall controversy

The 2004 tax system also hit British American Tobacco (BAT), a London-based multinational that had been wanting to penetrate the Philippines, too, like global rival, Philip Morris. BAT and Philip Morris are competing head-to-head in other Asian markets, such as Indonesia.

BAT raised hell on the impact of the 2004 code to its brand, Pall Mall. BAT, which had a licensing agreement with La Suerte, wanted to position Pall Mall as a mid-priced brand. However, a lengthy and controversial process that involved the interpretation of the law by the Bureau of Internal Revenue and the Finance Department ended up with a ruling that Pall Mall is a super-premium brand, subject to a whopping P27.16 sin tax per pack in 2009 and P28.30 in 2011.

In a country where the super-premium segment accounts for less than 1% of the market and sold at retail prices equivalent to 200% premium to Marlboro, the biggest selling brand in the Philippines, and over 4 times the price of Fortune, the leading brand in the mass market, BAT eventually decided it was a losing proposition. It pulled out Pall Mall from the Philippine market.

Throughout the Pall Mall controversy, representatives from PMPMI and Fortune were singing the same tune: that the tax law should be followed and the government has the right to raise the much-needed revenues.

While the 2004 tax scheme also affected PMPMI’s L&M brand (introduced in 2003), which was re-classified from mid-priced to a premium bracket, the cost of sacrificing one brand seemed less compared to keeping a rival (BAT) out of the Philippine territory.

After all, three is a crowd in a duopoly like the Philippine cigarette market.
By Lala Rimando, abs-cbnNEWS.com

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