Tax Gap for Federal Excise Duty on Cigarettes

On this page

• Executive Summary
• 1. Introduction
• 2. Background
  • 2.1 Excise Duties, Taxes, and Other Specific Levies
  • 2.2 Descriptive Statistics on Excise Duties, Taxes, and Other Specific Levies
  • 2.3 The Scope of Tax Gap Estimation
• 3. Estimating the Federal Cigarette Duty Gap
  • 3.1 Gap Analysis
    • 3.1.1 Methodology
    • 3.1.2 Results
    • 3.1.3 Limitations
  • 3.2 Econometric Model
    • 3.2.1 Methodology
    • 3.2.2 Results
    • 3.2.3 Limitations
  • 3.3 Average Federal Cigarette Duty Gap Estimate
• 4. The CRA’s Compliance Efforts in the Tobacco Industry
  • 4.1 The CRA’s Compliance Efforts in the Legal Sector
  • 4.2 The CRA’s Cooperation with Other Federal Departments and Agencies
• Conclusion
• Annex 1: Additional Information on Excise Duties, Taxes and Other Levies
  • A1.1 Excise Duties
  • A1.2 Excise Taxes
  • A1.3 Other Specific Levies
• Annex 2: Gap Analysis
• Annex 3: Econometric Model
• Glossary
• Bibliography

Executive Summary

In April 2016, the Government of Canada committed to estimating the federal tax gap to encourage an open and transparent discussion on tax non-compliance. Acting on this commitment, a dedicated unit was established at the Canada Revenue Agency (CRA) to examine and publish a series of reports analyzing different components of the federal tax gap. Building on previously published tax gap reports, this report examines tax non-compliance related to federal excise duties, taxes, and other specific levies.

The objective of this report is to estimate federal excise duties revenue loss from illegal production/smuggling of cigarettes^{Footnote 1}  (also referred in this report as the federal cigarette duty gap). In fact, illegal production/smuggling of cigarettes by unlicensed manufacturers is regarded as the main source of tax loss in relation to federal excise duties, taxes, and other specific levies in Canada (see section 2.3 for more details). For example, there are well-documented instances of an active illegal market of tobacco products in Canada and cigarette duties typically account for about 90% of the excise duty revenue from tobacco products for the federal government. This report does not estimate non-compliance for other products subject to excise duties, taxes, and other specific levies because there is limited scope for significant illegal production.^{Footnote 2}  To be consistent with CRA’s previous tax gap reports, the federal cigarette duty gap is estimated for tax year 2014. In addition, the results presented in this report do not take into consideration CRA’s audit results and, therefore, represent the gross tax gap. In fact, there are no tax audits for unregistered/non-filers from the illegal sector.

While the focus of this report is to estimate the federal cigarette duty gap, it begins by providing an overview of Canada’s overall excise regime. This not only helps Canadians to better understand excise duties, taxes, and other specific levies in Canada, it also establishes a baseline for future publications on other federal excise gaps. For example, the federal tax gaps related to cannabis excise duty and fuel charge are outside of the scope of this report since they were introduced in 2018 and 2019, respectively. However, they will be examined in a future tax gap report when we analyze these tax years.

Background on Excise Duties, Taxes, and Other Specific Levies

This report begins by providing a brief overview of the excise duties, taxes, and other specific levies in Canada, including the main obligations of excise licensees and registrants (see section 2.1 and Annex 1 for more details). Descriptive statistics are also presented for 2018-19. 

• Excise duties, taxes, and other specific levies are a relatively small source of tax revenue for the federal government accounting for around $12.1 billion in federal revenue, or about 4% of all federal tax revenue.
• Excise taxes on gasoline and excise duties on tobacco products generated nearly 65% of the excise duty and tax revenue for the federal government.

Estimating the Federal Cigarette Duty Gap

This report estimates the excise duty gap for cigarettes using two methods which rely on administrative tax data and external data sources. Based on the first method called gap analysis, the federal excise duty gap for cigarettes was estimated to be about $483 million for tax year 2014. An alternative approach, an econometric model was also used to estimate the gap. This second method uses an economic model based on an approach used in a C.D. Howe Institute study (2017) and which estimated the federal cigarette duty gap to be about $490 million for tax year 2014. Since the two estimates are relatively close in dollar value, an average was used (each was given equal weight). 

Therefore, the federal cigarette duty gap is estimated to be around $486 million for tax year 2014. This represents 16% of cigarette excise duty revenue, or about 4% of overall federal excise duties, taxes and other specific levies revenue.

CRA’s Compliance Efforts in the Tobacco Industry

For the tobacco industry, the CRA works with provinces/territories as well as other federal organizations such as the Canada Border Services Agency (CBSA) and the Royal Canadian Mounted Police (RCMP) to support compliance activities.

• The CRA plays a key role in Canada’s Tobacco Strategy, which is a comprehensive federal initiative led by Health Canada to reduce tobacco consumption among Canadians.
• The vast majority of tobacco licensees comply with their tax obligations.
• The CRA works with federal partners, including the CBSA and the RCMP to provide support and assistance in their efforts to combat contraband tobacco. 

Conclusion

The CRA is committed to improving its tax gap methodologies to leverage all of the data and methods available to create more accurate and pertinent estimates. In addition to this report, the CRA is also releasing a companion paper which calculates the payment tax gaps for income taxes (personal and corporate), the GST/HST and excise duties, taxes and other specific levies taxfilers for a particular taxation year. In 2021, an overall tax gap report will bring together all the components examined to date and update the tax gap figures up to tax year 2017. This overall tax gap report will also provide additional information on the impact of CRA audits in reducing the overall tax gap. Through an ongoing effort to understand different components of Canada’s tax gap, the CRA will continue to preserve the integrity of the tax system and protect Canada’s revenue base, which supports programs and benefits that improve the quality of life for all Canadians.

1. Introduction

The tax gap represents the difference between the taxes that would be paid if all obligations were fully met in all instances, and the tax actually paid and collected. The tax gap is a result of both intentional and unintentional actions ranging from deliberately hiding income to honest mistakes. In addition, changes to tax rules and economic events can affect the tax gap. For example, changes to a tax form can improve reporting compliance, while increased bankruptcies in a recession can make payment compliance worse. Therefore, tax gap levels are not fully under the control of the government. This also means that not every dollar of the tax gap can be collected (i.e., the tax gap will never be zero). However, the CRA’s compliance and outreach activities can help to reduce the federal tax gap in Canada.

The publication of tax gap estimates and their corresponding methodologies provide valuable information to the Government of Canada and the public on tax non-compliance and help deliver on the Government’s commitment to transparency. Understanding how and why taxpayers are non-compliant is critical to help preserve the integrity of the tax system and to protect Canada’s revenue base, which supports programs and benefits that improve the quality of life for all Canadians.

Given the complexity of tax gap estimation, the CRA has taken a step-by-step approach to develop appropriate and robust estimation methodologies that work within the Canadian context. Since 2016, the CRA has published five tax gap reports:

• A conceptual study on tax gap estimation (June 2016);
• An estimate of the tax gap for Goods and Services Tax and Harmonized Sales Tax (June 2016);
• A report on personal income tax compliance in Canada (June 2017);
• A report on tax compliance of individuals in the international context (June 2018); 
• A report on corporate income tax non-compliance (June 2019).

Building on CRA’s previous tax gap reports, this report examines federal tax non-compliance related to excise duties, taxes, and other specific levies with an exclusive focus on tobacco excise duties imposed under the Excise Act, 2001. Given that producers that remit excise duties on tobacco products are highly regulated and are generally compliant according to CRA’s compliance efforts in this industry, this report focuses on the illegal production of cigarettes by unlicensed manufacturers or smugglers who evade excise duties all together. This is because there are well-documented instances of an active illegal market of tobacco products in Canada and cigarette duties typically account for about 90% of the excise duty revenue from tobacco products for the federal government.

The CBSA is responsible for the collection of excise duty on imported tobacco products, control of imported tobacco products and the detection of tobacco products smuggled into Canada, primarily through border points. The RCMP is responsible for enforcement of the Excise Act, 2001, that involves non-licensees or licensees where criminal offences may apply.

To be consistent with CRA’s previous tax gap reports, the federal cigarette duty gap is estimated for tax year 2014. The federal tax gaps related to cannabis excise duty and fuel charge are outside of the scope of this report since they were introduced in 2018 and 2019, respectively. However, they will be examined in a future tax gap report when the data become available. The federal cigarette duty gap is estimated to be around $486 million for tax year 2014. This represents 16% of cigarette excise duty revenue, or about 4% of overall federal excise duties, taxes and other specific levies revenue.

In addition to this report, the CRA is also releasing another paper which estimates the payment gap for income taxes (personal and corporate), the GST/HST and excise duties and taxes. The CRA will continue to engage with interested stakeholders, the Parliamentary Budget Officer, and other external experts to further the CRA’s work in estimating Canada’s tax gaps. In 2021, an overall tax gap report will bring together all the components examined to date and update the tax gap figures up to tax year 2017. This overall tax gap report will also provide additional information on the impact of CRA audits in reducing the overall tax gap.

This report is organized as follows. Section 2 provides an overview of the excise duties and taxes in Canada, presents descriptive statistics on excise duties, taxes, and other specific levies, and outlines the scope of tax gap estimation presented in this report. Section 3 estimates the federal excise duty gap associated with cigarettes using two methods: gap analysis and econometric model. Section 4 provides a brief overview of CRA’s compliance efforts related to the tobacco industry.

2. Background

Excise duties and taxes (including other specific levies) are levies that are applied on a limited range of commodities and services. The purposes of excise duties and taxes are generally to raise revenue and to regulate specific products and services where there is a government or public interest (for example related to the environment or public health) to reduce the overall consumption of these products or services.

This section will provide an overview of excise duties and taxes in Canada (including other specific levies), present descriptive statistics, and outline the scope of the tax gap estimate presented in this report. The main obligations for taxpayers subject to these duties and taxes (commonly referred to as licensees and registrants) and federal excise duties and taxes rates are provided in Annex 1 of this report.

2.1 Excise Duties, Taxes, and Other Specific Levies 

In Canada, there are both excise duties and excise taxes. Excise duties are imposed under the Excise Act and the Excise Act, 2001 and apply to tobacco, alcohol, and cannabis. Excise legislation imposes duties at the production level, and includes controls on importation, production, distribution and possession of aforementioned goods (tobacco, alcohol and cannabis). Excise taxes are imposed under the Excise Tax Act and apply primarily to diesel fuel and gasoline. There are other specific levies on certain products and services, such as air transportation services, insurance premiums, and certain fuels (see Annex 1 for more details). 

As with previous tax gap reports, this section provides an overview of the particularities of the excise duties and taxes (including other specific levies). This overview allows for a better understanding of the context, notably that excisable products are highly regulated and there is little room for non-compliance. The only exception is the tobacco industry, where there is an active illegal market and therefore the tax gap estimation in this report focuses on the cigarettes only. More details on excise taxes, duties and other levies can be found in Annex 1.

Excise duties and taxes are generally not imposed directly on the consumer but are generally imposed on the products or services. The producer or importer of the goods remits the excise duty or tax. Excise duties and taxes are generally levied once after the product has been manufactured, packaged or has been imported. Therefore, they are distinct from sales taxes which are paid by both producers and consumers. 

In general, the CRA collects excise duties and taxes for domestically manufactured products while the CBSA collects them for imported products. For example, Figure 1 shows the federal excise duty revenue from tobacco products collected by the CRA (for domestically manufactured tobacco products) and by the CBSA (for imported tobacco products). Where excisable goods are imported by excise licensees or registrants on a deferral or exempt basis, responsibility for verifying the final use of those goods transfers to the CRA.

Figure 1: Federal Tobacco Excise Duty Revenue by Government Agencies, 2012-13 to 2018-19

Source: Public Accounts of Canada, from 2013-14 to 2018-19. 

Products that are subject to excise duties and taxes are highly regulated. Canadian companies manufacturing these products must obtain a licence and only licensees can legally produce excisable goods in Canada. Licensees normally report monthly on the products produced and remit the corresponding excise duty or tax to the CRA. Entities such as hospitals that are in possession of non-duty paid goods such as alcohols used to sanitize instruments, must register with the CRA.^{Footnote 3} 

The CRA has a broad mandate with respect to excise duties and taxes. It not only collects revenue, but it also plays a key role in regulating domestic production. All licensees and certain registrants are subject to periodic audits by the CRA to verify, for example, reported quantities of goods manufactured, inventories, and/or sales, as well as excise liabilities calculated. The CRA also conducts regulatory reviews of licensees and registrants such as checking whether excise stamps are applied correctly to tobacco or cannabis products. All registrations and excise tax licences are valid until they are cancelled or suspended by the CRA.

2.2 Descriptive Statistics on Excise Duties, Taxes, and Other Specific Levies 

As shown in Figure 2, excise duties, taxes, and other specific levies are a relatively small source of tax revenue for the federal government representing about 4% of all federal tax revenue. 

Figure 2: Share of Federal Excise Duties, Taxes, and Other Specific Levies in Total Federal Tax Revenue, 2018-19

Source: Public Accounts of Canada of 2018-19.
* Numbers may not add to 100% due to rounding.

As shown in Figure 3, the total amount of federal excise duties, taxes, and other specific levies increased between 2008-09 and 2018-19 by an average annual growth rate of 2.0%.^{Footnote 4}  The share of federal excise duties, taxes, and other specific levies declined slightly as a share of total federal tax revenue over the same period as other sources of tax revenue increased at a faster rate. In 2018-19, federal excise duties, taxes, and other specific levies accounted for around $12.1 billion in federal revenue.

Figure 3: Total Federal Excise Duties, Taxes, and Other Specific Levies, 2008-09 to 2018-19

Source: Public Accounts of Canada, from 2009-10 to 2018-19.

In 2018-19, the federal revenue from excise duties, taxes and other specific levies came mainly from excise taxes on gasoline and excise duties on tobacco products (see Figure 4). These two products generated nearly 65% of the excise duty and tax revenue for the federal government.

Figure 4: Excise duties, taxes and other specific levies revenue by type, 2018-19

Source: Public Accounts of Canada of 2018-19.

2.3 The Scope of Tax Gap Estimation 

In general, non-compliance can occur at the time of filing, reporting, or paying taxes. Registration/filing non-compliance occurs when taxpayers do not file their tax returns when they are required to do so. In the context of excise duties and taxes, the main source of registration/filing non-compliance occurs when goods from unlicensed or unregistered manufacturers/smugglers do not remit excise duties or taxes (e.g., contraband tobacco). Reporting non-compliance occurs when taxpayers fail to provide complete and/or accurate information in their tax return by under-reporting income, over-stating deductions, and/or claiming credits they are not entitled to. In the context of excise duties and taxes for example, licensees and registrants may understate the quantity of produced products and are not assessed correctly. Payment non-compliance occurs when taxpayers have tax owing that they do not pay in full or at all by the payment deadline. 

Figure 5: Types of Tax Non-Compliance in the Context of Excise Duties and Taxes

The tax gap analysis in this report focuses on capturing federal registration/filing non-compliance for tobacco products. 

There are well-documented instances of an active illegal market of tobacco products in Canada.^{Footnote 5}  The illegal production of cigarettes by unlicensed producers is regarded as the main source of the excise duty revenue loss in Canada. This is important because cigarette duties typically account for about 90% of the excise duty revenue from tobacco products for the federal government. 

This report does not estimate registration/filing non-compliance for other products subject to excise duties, taxes, and other specific levies because there is limited scope for significant illegal production.^{Footnote 6}  This is due, in part, to the nature of the commodity (e.g. weight, volume, variety, consumer demand elements, and higher costs related to production) and the required production infrastructure, which is difficult to conceal from the authorities. Certain small producers in the alcohol industry are exempt from paying federal excise duties and have no incentives for non-compliance. In addition, home brewing and winemaking are permitted and not subject to federal excise duties. A significant level of smuggling or illicit production is also unlikely in the alcohol sector due to an expected low level of demand for unregulated products considering potential health risks for consumers. Therefore, while the underground economy for alcoholic beverages could impact the tax gap related to, for example, sales taxes at the point of consumption, it is not expected to have a national impact on the level of non-compliance related to excise duties (at the production phase).

Although the CRA’s mandate is to regulate the legal tobacco market in Canada, the CRA works closely with federal partners, including the CBSA and the RCMP to support their enforcement efforts relative to contraband tobacco. The federal cigarette duty gap estimated in this report is not subject to CRA audits because the businesses or individuals involved in contraband are generally not licensees or registrants. That said, when contraband sales are uncovered, implicated parties are subject to the full extent of Canadian law either at the border or via the local or federal law enforcement bodies (e.g., RCMP). As well, entities who have been found to be producing illegal or contraband products subject to excise duties or taxes may be liable to penalties and fines, imprisonment or both. As such, the tax gap calculated in this report can be characterised as being a gross tax gap. It should be noted that there are no tax audits for unlicensed/non-filers from the illegal sector. 

Finally, it is important to note that the average rate of federal excise duty on cigarettes increased by almost 21% in 2014 compared to 2013.^{Footnote 7}  This increase may have changed the overall level of consumption and sales of tobacco products in Canada. Consequently, this may have had an impact on the overall cigarette excise duty gap. To be consistent with CRA’s previous tax gap reports, the federal cigarette duty gap is estimated for 2014.

3. Estimating the Federal Cigarette Duty Gap

This section estimates the federal excise duty gap associated with cigarettes, including those that are illegally produced in Canada as well as those that are smuggled from abroad. In selecting the methodology, the CRA chose a methodology using tax administrator’s taxpayer data (e.g. accounting data, and assessment data) and a methodology using independent external data (usually national accounts data or other external data).^{Footnote 11}  The estimate focuses on the illegal market for cigarettes which results in revenue loss (or an excise duty gap) because producers or smugglers of these cigarettes evade excise duties altogether. The CRA relied on administrative tax data and external data sources to produce two estimates of the federal cigarette duty gap.^{Footnote 12} 

First, a gap analysis was used to estimate the magnitude of illegal consumption of cigarettes, relying on administrative tax data and survey data from Statistics Canada. The federal excise duty rate for cigarettes was then applied to the estimated illegal consumption of cigarettes to estimate the gap. Second, an adaptation of an approach used in a C.D. Howe Institute study^{Footnote 13}  (econometric model) was used to estimate illegal cigarette sales and the corresponding federal excise duty loss. Since the two estimates are relatively close in dollar value, an average was used (each was given equal weight). 

The federal cigarette excise duty gap is estimated to be around $486 million for tax year 2014. This represents 16% of cigarette excise duty revenue, or about 4% of overall federal excise duties, taxes and other specific levies revenue.^{Footnote 14} 

The methodologies, results, and limitations of these two approaches are explained in greater detail below.

3.1 Gap Analysis 

Gap analysis is a common method used to estimate tax non-compliance for tobacco products, including cigarettes.^{Footnote 15}  It is also aligned with the approach used by the United Kingdom to estimate the tax gap for excise duties on tobacco products.^{Footnote 16}  In general, this method estimates the potential consumption of illegal cigarettes by comparing total consumption levels with legal consumption levels. The excise duty rate is then applied to the assumed level of illegal consumption to estimate tax loss. This section provides an overview of the methodology, results, and potential limitations of the gap analysis approach. 

3.1.1 Methodology

To estimate the cigarette duty gap arising from contraband, the first step was to estimate the potential magnitude of illegal consumption of cigarettes in Canada. Illegal consumption was estimated by taking the difference between total consumption and legal consumption of cigarettes in 2014.

Legal consumption was based on 2014 administrative tax data from the CRA, CBSA and Health Canada. In particular, the number of tax-paid cigarettes was calculated using tax information from manufacturers in Canada, importers of cigarettes, and duty-free shops. In addition to tax-paid cigarettes, legal consumption also include roll-your-own (RYO) cigarettes. To estimate RYO cigarettes, we used cigarette fine-cut tobacco sales data, expressed in units of weight (kilograms), as reported by tobacco manufacturers to Health Canada. We have converted fine-cut tobacco sales into number of cigarettes using 0.75 gram conversion factor.^{Footnote 17} 

Total consumption was estimated based on the total number cigarettes consumed in 2014 by the Canadian population (aged 15 years or older) based on the Canadian Community Health Survey (CCHS) for 2014 conducted by Statistics Canada. In particular, survey results related to smoking prevalence rates (percentage of smokers in Canada) and smoking intensity (average number of cigarettes smoked by daily and occasional smokers) were used. Since survey data is often subject to under-reporting, an uplift factor was used to correct for this bias.^{Footnote 18}  This report uses the 35% underreporting rate estimated by Guindon et al. (2017), corresponding to an uplift factor of 1.54 (see Annex 1 for details).^{Footnote 19}  This adjustment is consistent with the United Kingdom’s approach to estimating their cigarette excise duty gap.^{Footnote 20} 

The federal cigarette duty tax gap was then estimated by multiplying the average federal cigarette duty rate (for five cigarettes) by the magnitude of the illegal consumption (number of illegal cigarettes). 

Additional details on the methodology are provided in Annex 1.

3.1.2 Results 

In 2014, there were 29.7 million people in the total Canadian population aged 15 or older.^{Footnote 21}  According to CCHS data, 14% of this population were estimated to be daily smokers and 5% were non-daily smokers. Based on this, the average number of cigarettes consumed in 2014 was estimated to be 22.85 billion, before correcting for the under-reporting bias. 

After applying an uplift factor of 1.54 to account for the under-reporting bias, it is estimated that around 35.15 billion cigarettes were smoked in 2014. Based on administrative tax data, around 30.46 billion cigarettes were consumed legally in 2014. Therefore, the illegal consumption accounts for an estimated 4.69 billion cigarettes or 13% of total consumption in 2014.^{Footnote 22}

Applying the average federal duty rate for cigarettes in 2014 ($0.514 per five cigarettes) to the 4.69 billion illegal cigarettes, the federal cigarette duty gap is estimated to be about $483 million for tax year 2014. This represents 16% of cigarette excise duty revenue, or about 4% of overall federal excise duties, taxes and other specific levies revenue.^{Footnote 23}  Figure 6 summarizes the estimation of the federal cigarette duty gap using gap analysis.

Figure 6: Estimation of the Federal Cigarette Duty Gap using Gap Analysis*

* Numbers may not add up due to rounding.

3.1.3 Limitations 

There are a few general limitations to gap analysis.

This report focused on individuals living in Canada aged 15 or older and therefore, it does not account for those under the age of 15 or visitors to Canada who are smokers.^{Footnote 24}  However, this consumption is minor compared to overall consumption. 

In addition, legal consumption was estimated using administrative tax data which reflects sales or deliveries to wholesalers rather than direct consumers of cigarettes.^{Footnote 25}  

Although legal consumption captures most cigarette sales in Canada, it does not include all cigarettes purchased from abroad, such as cigarettes purchased by travellers returning to Canada.

The most important limitation of this method is that it is quite sensitive to the assumption which determines the uplift factor used to estimate total consumption of cigarettes. In this report, it is assumed that 35% of cigarettes were unaccounted for in the survey data in 2014 due to under-reporting by survey respondents. However, if this assumption is modified, the federal cigarette duty gap is subject to significant change (see the sensitivity analysis in Annex 1 for more details). Therefore, an alternative approach (econometric model) was also used to confirm that the federal cigarette duty gap estimate was reasonable.

3.2 Econometric Model

The second method is based on the approach developed by the CD Howe (2017) and uses publicly available data from Statistics Canada and Health Canada to estimate legal sales (considered as a proxy to total demand for cigarettes) that should have occurred if the level of contraband cigarettes was very low.^{Footnote 26}  To estimate the level of illegal cigarette sales, the difference was taken between estimated legal sales (based on data for years when consumption was very low) and actual legal sales. The federal excise duty rate for cigarettes is then applied to the estimated illegal sales to calculate the cigarette excise duty gap. This section provides an overview of the methodology, results of the econometric model, and potential limitations.  

3.2.1 Methodology

The first step of the econometric model examines the relationship between factors that explain cigarettes consumption, such as cigarette price and disposable income, and legal cigarette sales during a time when there was a low level of contraband cigarettes (1996-2004).^{Footnote 27}  These explanatory factors were then used to estimate legal cigarette sales for Canada’s six most populous provinces: Ontario, Quebec, British Columbia, Alberta, Saskatchewan, and Manitoba.^{Footnote 28} 

The estimation results from the first step were then used to predict the potential amount of legal cigarette sales for other years (due to the limited presence of contraband during step one). Therefore, the second step of the econometric model estimates legal sales that should have occurred during 2005-2017 if the level of contraband cigarettes was very low and the relationship between cigarette sales and its determinants remains constant over time. But, due to the presence of contraband, the estimated legal sales are higher than the actual legal sales recorded during these years. Therefore, subtracting actual legal sales from the estimated legal sales provides an estimate of illegal cigarette sales. 

To estimate the federal cigarette excise duty gap, the average federal duty rate for cigarettes for 2014 (for five cigarettes) was applied to the estimated number of illegal cigarettes in 2014.

Additional details on the methodology is provided in Annex 2.

3.2.2 Results

Based on the results from the econometric model, it was estimated that there should have been around 32.48 billion cigarettes that were legally sold in 2014, if the level of contraband was low (as in the 1996 to 2004 period). However, records of actual legal cigarette sales indicate that around 27.71 billion cigarettes were sold in 2014.^{Footnote 29}  Therefore, it is estimated that around 4.77 billion cigarettes were sold illegally. 

After applying the average federal duty rate in 2014 to the number of illegal cigarettes, the federal cigarette duty gap is estimated to be $490 million for tax year 2014. This represents 16% of cigarette excise duty revenue, or about 4% of overall federal excise duties, taxes and other specific levies revenue.^{Footnote 30}  Figure 7 summarizes the estimation of the federal cigarette duty gap using an econometric model.

Figure 7: Estimation of the Federal Cigarette Duty Gap using an Econometric model*

* Numbers may not add up due to rounding.

3.2.3 Limitations

The econometric modelling method has certain limitations. 

• First, the tax gap estimate can vary depending on the explanatory factors chosen to estimate the total consumption of cigarettes. To reduce bias, multiple sets of explanatory factors were used to estimate potential legal cigarette sales (and many more were tested). See Annex 3 for details. 
• Second, the tax gap estimate could be higher if the assumption that illegal cigarette sales were low during the 1996 to 2004 period is invalid.
• Third, the structural relationship between cigarette sales and its determinants might have changed between 1996-2004 and 2005-2017 periods.
• Finally, the tax gap estimate is based on the econometric results from six provinces. However, this limitation is expected to be relatively minor since the six provinces analyzed represent 92% of total legal cigarette sales in 2014.^{Footnote 31}   

3.3 Average Federal Cigarette Duty Gap Estimate 

To recap, the federal cigarette duty gap estimate from gap analysis was $483 million for tax year 2014. Using an econometric model, the second method estimated the federal cigarette duty gap to be around $490 million. Since the two estimates are relatively close in dollar value, an average was used (each was given equal weight). Therefore, the federal cigarette excise duty gap is estimated at $486 million for tax year 2014. This represents 16% of cigarette excise duty revenue, or about 4% of overall federal excise duties, taxes and other specific levies revenue.

Of note, this federal cigarettes duty gap may not be completely recoverable since smokers of illicit tobacco may reduce their consumption if they have to pay cigarettes at a higher legal price that includes tobacco duty, when all illicit cigarettes become legal.

It is very difficult to know how the contraband market in Canada will evolve due to the many changes that have been observed in recent years. There is a declining trend in the smoking rate that is likely to continue. At the same time, cigarette prices have risen sharply in recent years, mostly as a result of tax increases on tobacco products put in place by the various levels of government. Finally, it should also be noted that there was an increase in the consumption of electronic cigarettes or vaping in recent years.

4. The CRA’s Compliance Efforts in the Tobacco Industry

Globally, tax compliance is a key priority for the Government to ensure that taxpayers meet their tax obligations and receive applicable credits and benefits. In the context of excise duties, taxes, and other specific levies, the CRA also strives to ensure the proper regulation of excisable products. Therefore, the CRA’s activities (a) ensure that excise duties, taxes, and other specific levies are properly reported and remitted on products based on legislative requirements, (b) ensure revenues reported but deferred or exempt from payment meet legislative requirements, and (c) regulate the production, storage, and movement of products subject to excise duties in cooperation with other federal departments and agencies.

In the context of the tobacco industry, the CRA’s responsibilities is to ensure compliance with the Excise Act, 2001, which governs federal tobacco taxation and regulates certain activities related to the manufacturing, possession, and sale of tobacco products. The CRA conducts audits and regulatory reviews of tobacco manufacturers and distributors licensed under legislation and ensures that the stamping and marking requirements are met.

The CBSA is responsible for the collection of excise duty on imported tobacco products, control of imported tobacco products and the detection of tobacco products smuggled into Canada, primarily through border points. The RCMP is responsible for enforcement of the Excise Act, 2001, that involves non-licensees or licensees where criminal offences may apply. This section will provide an overview of compliance efforts specifically related to tobacco products, including the CRA’s work with other federal organizations such as the CBSA, Health Canada, and the RCMP.

4.1 The CRA’s Compliance Efforts in the Legal Sector

The CRA’s Excise Duty Program ensures that tobacco licence applications are reviewed thoroughly to ensure that they meet the eligibility requirement set out in the Excise Act, 2001 and the Regulations Respecting Excise Licenses and Registrations. Tobacco licences must be renewed at minimum of every two years. Excise officers will review the applicant’s:

• Business plan for reasonableness and to ensure the correct licence is being sought;
• Financial resources to determine financial capabilities to operate;
• Application to ensure it is complete;
• CRA records to determine if there are concerns related to past compliance; and
• Amount of security posted to ensure it is adequate to cover the highest expected monthly duty to be paid in a year.

As well, the excise officer will:

• Request a criminal background check; and
• Conduct a visit of the premises to verify the information on the application and the business plan. 

To ensure that Canada’s tobacco legislation is applied effectively, the CRA works with other government departments and agencies including the RCMP, CBSA and Department of Justice. In addition, the CRA’s tobacco taxation activities play an important role in Canada’s Tobacco Strategy (CTS), which is a comprehensive federal initiative led by Health Canada to reduce tobacco consumption among Canadians. The CRA receives additional funding under the CTS which allows the CRA to conduct full audits of each tobacco licensee every year. Furthermore, it allows the CRA to conduct a minimum of eight regulatory review visits per location, based on risk assessment and compliance history. In particular, regulatory reviews may include verification of exports, inventories of raw materials, and other specific production and reporting activities.

4.2 The CRA’s Cooperation with Other Federal Departments and Agencies

The CRA also consults with provinces and territories, the Department of Finance, Health Canada and other federal departments and agencies on the development of administrative and legislative proposals related to tobacco control and taxation. The CRA has held and continues to hold the Chair of the Federal-Provincial-Territorial Tobacco Steering Committee for several years.

Finally, the CRA assists the RCMP and the Department of Justice by providing technical expertise and administrative enforcement services. Examples include providing affidavits and/or expert court witness testimony that an accused holds or does not hold a licence or has any legal reason to possess unstamped tobacco or to explain the workings of the excise tobacco regulatory framework to a court. 

The vast majority of tobacco licensees comply with their tax obligations. In general, non-compliance is primarily a result of smuggling or unlicensed tobacco production.

Conclusion

This report examined tax non-compliance related to excise duties, taxes, and other specific levies. For 2018-19, excise duties, taxes, and other specific levies accounted for around $12.1 billion in federal revenue, representing about 4% of all federal tax revenue. Excise taxes on gasoline and excise duties on tobacco products generated nearly 65% of the excise duty and tax revenue for the federal government.

The scope of this tax gap estimation is to capture federal tax revenue loss from the illegal production or smuggling of cigarettes by unlicensed producers. It does not estimate registration/filing non-compliance for other products subject to excise duties, taxes, and other specific levies because there is limited scope for significant illegal production. To be consistent with CRA’s previous tax gap reports, the federal cigarette duty gap is estimated for tax year 2014.

Relying on two methods of estimation, the federal cigarette duty gap is estimated to be $486 million for tax year 2014. This represents 16% of cigarette excise duty revenue, or about 4% of overall federal excise duties, taxes and other specific levies revenue.

Combining the federal cigarette duty gap with other tax gap components previously published by the CRA increases Canada’s federal tax gap by around half a billion dollars for tax year 2014. Canada’s federal tax gap for tax year 2014 is estimated to be between $20.1 billion and $24.3 billion or between 9.2% and 11.2% of corresponding revenues - before considering the impact of audits (see Table 1). The payment tax gap figures are not included in the following table and cannot be directly added to those estimates without special methodological considerations.

Table 1: Canada’s Federal Tax Gap Estimates Before Audit for Tax Year 2014 (excluding payment gap)

* Percentages of corresponding revenues are based on federal tax revenues from the 2014-15 fiscal year as published in the Public Accounts of Canada 2015-2016.
** The tax gap for excise duty and tax focuses on the non-filing/non-registration gap. Currently, the excise duty and tax gap measures foregone tax revenue from illegal production or smuggling of cigarettes. This figure will be updated as the CRA measures foregone revenues from other excise duties and taxes.
Note: All amounts are in nominal dollars.

CRA’s compliance efforts have been instrumental in maintaining a high level of compliance in the tobacco industry. In addition, the CRA works with federal partners, including the CBSA and the RCMP to provide support and assistance in their efforts to combat contraband tobacco. 

In addition to this report, the CRA is also releasing a companion paper which estimates the payment gap for income taxes (personal and corporate), the GST/HST and excise duties and taxes. In 2021, an overall tax gap report will bring together all the components examined to date and update the tax gap figures up to tax year 2017. This overall tax gap report will also provide additional information on the impact of CRA audits in reducing the overall tax gap. Through an ongoing effort to understand different components of Canada’s tax gap, the CRA will continue to preserve the integrity of the tax system and protect Canada’s revenue base that supports programs and benefits that improve the quality of life for all Canadians.

Annex 1: Additional Information on Excise Duties, Taxes and Other Levies

A1.1 Excise Duties

Table A1 and A2 below provide an overview of excise duty rates effective April 1, 2020.^{Footnote 35} 

Table A1: Summary of Federal Excise Duty Rates

Source: CRA – Excise Duty Rates. 

* Rates are effective April 1^st, 2020.
** For spirits of not more than 7% of absolute ethyl alcohol by volume, the rate is per litre. For spirits of more than 7% of absolute ethyl alcohol by volume, the rate is per litre of absolute ethyl alcohol.
*** These are regular rates. Rates are discounted depending on production of the brewery, for example the rate is discounted 90% on the first 2,000 Hl of beer produced.
**** Wine produced from 100% Canadian agricultural products and small wineries who do not sell more than $50,000 of wine packaged in Canada in a year, do not remit excise duty but still have reporting obligations. 

Table A2: Federal Cannabis Duty Rates

Source: CRA – Excise Duty Rates.
* Rates are effective April 1st, 2020.
** The excise duty for cannabis products is the maximum between the ad valorem rate the and flat rate, where applicable, without any sales tax adjustments.
*** There are no additional cannabis excise duty in Manitoba as it is not a signatory of the Coordinated Cannabis Taxation Agreement with the federal government. 

Under the Excise Act, 2001, licences for products subject to excise duties are issued for a maximum period of two years. Licensees must reapply not less than 30 days from the date of expiry in order to be considered for renewal. Possession, usage, storage, or transportation of non-duty paid alcohol products sometimes also requires registration under the Excise Act, 2001.^{Footnote 36}  

Under the Excise Act, brewery licensees must also pay an annual licence fee.

A1.2 Excise Taxes

Table A3 provides an overview of excise tax rates in 2020 for products subject to excise taxes. 

Table A3: Summary of Federal Excise Tax Rates

Source: CRA – Excise Tax Rates. 
* These rates are in place since April 2008.

Unlike the excise duty licensees, licensed manufacturers under the Excise Tax Act do not need to apply every two years to renew their excise tax licence. As well, small Canadian manufacturers with total annual sales below $50,000 are not obliged to obtain a licence nor pay the excise tax to the CRA. ^{Footnote 37}

A1.3 Other Specific Levies

In addition to excise duties and taxes, other specific levies are imposed on certain products and services such as air transportation services, insurance premiums, and certain fuels. They are briefly discussed below. 

Air Travellers Security Charge 

Under the Air Travellers Security Charge Act, all designated air carriers that provide air transportation services to individuals that include a chargeable emplanement must collect a charge.

This charge varies depending on the destination, the type of connection or stopover, and whether the GST/HST is applied or not to the rate.^{Footnote 38} The charge can range from $7.12 to $25.91.

Transport Canada is responsible to identify airlines that must be registered by the CRA.

Insurance Premium Tax

A 10% federal tax is applied to certain insurance premiums such as those that are placed with authorized insurers outside Canada or purchased through a broker or agent outside of Canada.^{Footnote 39}  This tax is the oldest excise tax and mainly affects corporations buying insurance.^{Footnote 40}

Fuel Charge

The federal carbon pollution pricing system was introduced in 2019 through the Greenhouse Gas Pollution Pricing Act. The CRA only administers Part I of this Act which contains the fuel charge.^{Footnote 41}  This fuel charge will increase progressively from $30 per tonne of carbon pollution in 2020, to $50 per tonne in 2022. It is payable by producers, certain users, or distributors of fossil fuels. Currently, the fuel charge only applies to provinces or territories that do not have a carbon pricing mechanism in place. These provinces and territories were Saskatchewan, Manitoba, Alberta, Ontario, Nunavut, and Yukon. Proceeds from the fuel charge are currently returned to the individuals living in Ontario, Manitoba, Saskatchewan and Alberta through the Climate Action Incentive Payment. The payment can be claimed when individuals file their personal income tax returns. For Nunavut and Yukon, who voluntarily adopted the federal system, the proceeds are returned directly to the governments of those jurisdictions.

Annex 2: Gap Analysis

Gap analysis is a method often used to estimate tax non-compliance related to contraband cigarettes.^{Footnote 42}  To estimate the federal cigarette duty gap arising from contraband, four steps are taken. 

Step 1: Total Consumption Estimate 

The total reported consumption was calculated based on the total number of cigarettes consumed by the Canadian population aged 15 or older^{Footnote 43}  based on the Canadian Community Health Survey (CCHS) conducted by Statistics Canada.^{Footnote 44}  In particular, survey results related to smoking prevalence rates (percentage of smokers in Canada) and smoking intensity (average number of cigarettes smoked per day by daily and occasional smokers) were used. It is assumed that the cigarette consumption habits of the population excluded from CCHS sampling frame are identical to those of the rest of the Canadian population aged 15 years and older.^{Footnote 45}  The total reported consumption was the summation of reported consumption from daily smokers and occasional smokers.

Since survey data on smoking prevalence is often subject to under-reporting, an uplift factor was applied to correct for this bias. Under-reporting can generally occur when respondents: 

• Indicate they are a non-smoker when they are a smoker;
• Indicate they are an occasional smoker when they are a frequent or daily smoker, and/or;
• Inaccurately report the number of cigarettes consumed per day.

Step 2: Legal Consumption Estimate

Legal consumption in Canada was calculated based on administrative tax data from the CRA, the CBSA and Health Canada. The number of tax-paid cigarettes was estimated using tax information from manufacturers in Canada, importers of cigarettes, and duty-free shops.^{Footnote 46}  In addition to tax-paid cigarettes, legal consumption also include roll-your-own (RYO) cigarettes. To estimate RYO cigarettes, we used cigarette fine-cut tobacco sales data, expressed in units of weight (kilograms), as reported by tobacco manufacturers to Health Canada. The number of cigarettes that have expired or have been exported are subtracted since there are quantities for which producers or importers are entitled to claim reimbursements (referred to as "refunds"). 

Step 3: Illegal Consumption Estimate

Illegal consumption was estimated by taking the difference between total consumption and legal consumption of cigarettes.

Step 4: Federal Cigarette Duty Gap Estimate

To estimate the federal cigarette excise duty gap, the average federal duty rate for cigarettes for 2014 (for five cigarettes) was applied to the estimated number of illegal cigarettes in 2014. The average federal duty rate corresponds to the average of the official duty rates on daily basis between January 1st and December 31^st, 2014.

Sensitivity Analysis

The federal cigarette duty gap estimate under gap analysis relied on the assumption that around 35% of cigarette consumption was not captured by Statistics Canada’s survey data. As shown in Table A4, the tax gap estimate was found to be quite sensitive to this assumption. For illustrative purposes, we chose two values below the 35% underreporting rate and two values above it to demonstrate the degree of sensitivity. Given the sensitivity to this assumption, an econometric approach was also used (see Annex 3) to confirm that an uplift factor of 1.54 was reasonable.

*Figures may not add due to rounding.

Annex 3: Econometric Model

The second method is an econometric model which uses publicly available data from Statistics Canada and Health Canada to estimate legal sales that should have occurred if the level of contraband cigarettes was very low. This methodology builds on the approach used by the C.D. Howe Institute (2017) to estimate contraband cigarette sales in Ontario and Quebec.^{Footnote 47}  To estimate the federal cigarette duty gap arising from contraband, four steps are taken. 

Step 1: Estimate Legal Cigarette Sales during 1996-2004

The first step of the econometric model examines the relationship between explanatory variables, such as cigarette price and disposable income, and cigarette sales per capita during a time when there was a low level of illegal cigarette sales (1996-2004).^{Footnote 48}  To be consistent with the gap analysis method, the econometric model also examined individuals aged 15 or over in Canada and included RYO cigarettes sales estimated from wholesales data. The list of the explanatory factors used are presented in Box A1.^{Footnote 49}  Using a regression model, these explanatory factors were used to estimate legal cigarette sales for Canada’s six most populous provinces: Ontario, Quebec, British Columbia, Alberta, Saskatchewan, and Manitoba.^{Footnote 50} 

Step 2: Estimate Legal Cigarette Sales during 2005-2017 

The estimation results from the first step can be used to predict the potential amount of legal cigarette sales for other years as if there was a limited presence of contraband during that period. Therefore, the second step of the econometric model estimates legal sales that should have occurred during 2005-2017 if the level of contraband cigarettes was very low.

Step 3: Estimate Illegal Cigarette Sales in 2014

Due to the presence of contraband, the estimated legal sales is higher than the actual legal sales recorded during 2005-17. Therefore, subtracting actual legal sales from the estimated legal sales results in an estimate of illegal cigarette sales. 

To be consistent with previously published tax gap reports, illegal sales was estimated for 2014. 

Step 4: Estimate Federal Cigarette Duty Gap 

To estimate the federal cigarette excise duty gap, the average federal duty rate for cigarettes for 2014 (for five cigarettes) was applied to the estimated number of illegal cigarettes in 2014. 

Glossary

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