Importers of smoking tobacco products, particularly cigarettes, are increasingly saving millions in federal excise taxes by employing a refund mechanism known as the “drawback.”
A recent report published by the U.S. Government and Accountability Office found that importers of smoking tobacco products have requested $898 million in drawback refunds since fiscal year 2019, and the U.S. Congress’ Joint Committee on Taxation estimated that the drawback mechanism could result in more than $12 billion in cigarette tax refunds over the next decade.
So, what is the drawback?
A “drawback” is a type of refund of customs duties on imported merchandise. Under U.S. customs laws, importers who pay duties, including federal excise taxes on cigarettes and other tobacco products, can seek a drawback of those duties in certain circumstances, including when the products are subsequently exported or destroyed rather than sold to U.S. consumers (referred to as the “unused merchandise” drawback). These drawback provisions are intended, in part, to promote exports to allow companies to compete in foreign markets.
One might think that a company could only obtain an unused merchandise drawback for products exported where those same products had been subjected to the federal duties and taxes. Drawbacks, however, are not so limited.
Under current U.S. customs laws, an importer can obtain a drawback through use of “substitution” provisions. For example, if a company pays $1.01 in federal excise taxes on a pack of Cigarette A, then the company can obtain a refund of 99% of the taxes paid on the pack of Cigarette A when it exports a pack of domestically manufactured Cigarette B, provided that Cigarette B is sufficiently similar to Cigarette A. This is true even if the company never had to pay federal excise taxes on Cigarette B. In effect, the company can obtain almost a full offset of its federal excise taxes paid on Cigarette A.
The importer can also get an additional tax break — at least a temporary one — by storing a pack of Cigarette A in a customs-bonded warehouse upon importation, which allows the importer to delay payment of federal excise taxes for up to five years.
Tobacco companies’ use of this arrangement has steadily increased since the Trade Facilitation and Trade Enforcement Act of 2015 (TFTEA). Among other things, the TFTEA replaced a subjective “commercially interchangeable” standard to determine eligibility for a substitution drawback with a simple requirement that the exported good share the same Harmonized Tariff Schedule code as the imported good. This straightforward standard allows more goods to qualify for substitution.
It remains to be seen, however, whether the status quo will hold. Although it was ultimately stripped from Congress’ One Big Beautiful Bill Act earlier this year, an earlier version of the bill would have limited the drawback of federal excise taxes for tobacco products to scenarios where excise taxes had been paid on the exported goods used as the basis for the drawback claim.
