Tobacco Trade: Duty-Free Cigarettes Sold in Unlimited Quantities on the U.S.-Mexico Border Pose Customs Challenges

Since the 1970s, U.S. agencies have recognized that high-volume cigarette sales at duty-free stores near the U.S.–Mexico land border, although lawful, could be related to illicit activity. In 1988, U.S. law limited the quantity of duty-free tobacco products an individual can purchase at stores located in airports, restricting the sale of tobacco products to quantities consistent with personal use. This requirement, however, does not apply to land border duty-free stores.

GAO was asked to review information on sales of cigarettes at duty-free stores along the southwest border. CBP identified 88 such stores and warehouses. This report describes (1) requirements that govern the lawful sale and export of cigarettes from duty-free stores on the southwest border and schemes for illicit trade in such cigarettes, (2) U.S. agency observations about these exports and efforts to counter illicit trade, (3) the extent to which selected cigarette transaction data submitted by duty-free stores indicate compliance issues. GAO analyzed Census data on these exports; reviewed CBP, ICE, and Department of the Treasury documents; and interviewed agency officials in Washington, D.C., and in several ports along the southwest border, including Laredo, Texas, and the San Diego, California, area.

Duty-free stores at the southwest border may sell tax-exempt cigarettes in any quantity to passengers departing the United States for Mexico; agencies have identified schemes associated with duty-free cigarette sales used to evade U.S. and Mexican taxes. U.S. Customs and Border Protection (CBP), an agency within the Department of Homeland Security (DHS), regulates duty-free stores. U.S. regulations require the stores to have procedures to provide reasonable assurance of export of cigarettes and the exporter to report export information on transactions valued at over $2,500. U.S. Census Bureau (Census) data show that about 18,500 such transactions involving cigarettes occurred from 2010 to 2015. According to information from U.S. and Mexican officials, the Mexican government limits the amount of duty-free cigarettes that can be brought into Mexico (see figure). U.S. agencies identified three schemes to evade U.S. and Mexican cigarette-related tax and other laws: (1) diversion from a duty-free store into U.S. commerce; (2) smuggling into Mexico through U.S. ports; and (3) smuggling back into the United States after export to Mexico.

U.S. agency officials said that some smuggling of duty-free cigarettes across the southwest border has links to organized crime, supplies the illicit tobacco market in Mexico, and poses oversight and enforcement challenges. U.S. Immigration and Customs Enforcement (ICE) officials said they have identified links between the smuggling of large quantities of duty-free cigarettes and transnational criminal organizations that use the smuggled cigarettes to launder money and generate revenue. Inexpensive cigarettes made in the United States are part of the trade in duty-free cigarettes along the southwest border, including brands that a Mexican official stated are prohibited for sale in Mexico. U.S. officials reported that their efforts to counter the illicit trade in duty-free cigarettes face challenges, primarily due to the ability to buy unlimited quantities of duty-free cigarettes at the land border.

According to CBP, in many cases, duty-free stores on the southwest border are filing noncompliant information that they are required to report on cigarette exports valued at more than $2,500. For example, officials had compliance concerns with filings in which stores identify themselves, and not the purchaser, as the exporter. CBP and Census have met with representatives of one of the largest operators of duty-free stores on the southwest border to clarify regulatory requirements. However, CBP officials said that this duty-free store operator continues to make incorrect filings. CBP has not issued guidance to all operators to clarify the correct procedure. Without accurate export data, agencies may lack the information they need to enhance their enforcement and intelligence efforts.

CBP should take steps to strengthen compliance with export reporting requirements for duty-free cigarette sales on the southwest border, such as issuing guidance to all duty-free store operators. DHS agreed and noted CBP plans to address the recommendation.

Since the 1970s, U.S. agencies have recognized that high-volume  tobacco sales at duty-free stores near the southwest U.S. border,  although lawful, could be related to illicit activity. The U.S. government  permits sales of tobacco products at duty-free stores near U.S. points of  exit. According to our analysis of agency data and our communications  with U.S. agency officials, cigarettes are the primary tobacco export from  duty-free stores on the southwest border. According to federal and state  government officials, increases in cigarette taxes in Mexico in 2010 and in  border states such as California in April 2017 have elevated the risk of  cross-border cigarette smuggling from all sources, including duty-free  stores. In a 2014 committee report, the House of Representatives  Committee on Appropriations noted its understanding that nearly one in  four packs of cigarettes consumed in Texas is smuggled in from Mexico.

You asked us to review issues related to sales of cigarettes at duty-free  stores along the southwest border of the United States. We examined (1)  requirements that govern the lawful sale and export of cigarettes from  duty-free stores on the southwest border and schemes for illicit trade in  such cigarettes that agencies identified, (2) U.S. agency observations  about these duty-free cigarette exports and efforts to counter illicit trade,  and (3) the extent to which selected cigarette transaction data submitted  by duty-free stores indicate compliance issues with reporting  requirements.

To address the objectives, we reviewed relevant federal laws, regulations,  and agency documents. We also interviewed officials from the  Department of Commerce’s (Commerce) U.S. Census Bureau (Census);  the Department of Homeland Security’s (DHS) U.S. Customs and Border  Protection (CBP) and U.S. Immigration and Customs Enforcement (ICE);  the Department of Justice’s (DOJ) Bureau of Alcohol, Tobacco, Firearms,  and Explosives (ATF); the Department of the Treasury’s (Treasury)  Alcohol and Tobacco Tax and Trade Bureau (TTB); and tax-collecting  officials from the California state government’s Board of Equalization. In  addition, we conducted fieldwork at the ports in Laredo, Texas; and the  San Diego, California, area, including the ports of Otay Mesa and San  Ysidro; we also interviewed cognizant officials in Los Angeles, California.

To describe how duty-free cigarettes are sold and exported and how duty- free stores report data, we analyzed Automated Export System (AES)  data from Census for 2010 through 2015 on recorded transactions at the  88 duty-free stores CBP identified as being adjacent to the U.S.-Mexico  border, also referred to as the southwest border, spanning Texas, New  Mexico, Arizona, and California (see fig. 1). We determined that data  were sufficiently reliable to review filing practices with respect to duty-free  cigarette transactions. We determined that value and quantity data for  those transactions were not reliable for the purposes of this report due to  unexplained variations in the calculated prices; we based our assessment  on a review of related documentation and on interviews with Census  officials about the agency’s procedures to ensure the quality of the data  and interviews with CBP officials to discuss relevant aspects of how  transaction data might be entered in AES. See appendix I for more details  on our scope and methodology and appendix II for our assessment of  AES data reliability.

We conducted this performance audit from November 2016 to October  2017 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.

19 U.S.C. § 1555(b)(8)(D). portion was then being smuggled back into the United States without  payment of U.S. taxes.

Congress legislated on duty-free stores through the Omnibus Foreign  Trade and Competitiveness Act of 1988, which required duty-free stores  located in airports to restrict the sale of duty-free merchandise to any one  individual to “personal use quantities,” which is defined as “quantities only  suitable for uses other than resale.”10 During consideration of the  legislative language that was enacted in 1988, a senator introduced an  amendment to permit duty-free stores located along the border to  continue to sell goods in wholesale quantities. In introducing the  amendment, the senator observed that a large part of the sales by the  border stores along the U.S.-Mexico border were in wholesale quantities  and that restricting the stores’ ability to sell in such quantities would  adversely affect the stores’ business and the regional economy.  Congress adopted the law with the amendment and applied the concept  of “personal use quantities” only to airport duty-free stores.12 This  requirement does not apply to land border stores.

Agencies with Roles Related to Duty-Free Cigarette Exports

Pub. L. No. 100-418, § 1908(b), 102 Stat. 1107, 1315 (codified as amended at 19  U.S.C. § 1555(b)). The act does not identify any quantity amount with respect to personal  use but defines personal use quantities as quantities that are only suitable for uses other  than resale and includes reasonable quantities for household or family consumption as  well as for gifts to others.

Discussion of this topic occurred as part of congressional consideration of Senate Bill  1420, the Omnibus Trade and Competitiveness Act of 1987. One senator highlighted the  potential for economic harm to communities adjacent to the U.S.-Mexico border if the  provision precluding duty-free sales in wholesale quantities were applied to land border  stores. Congress passed the Omnibus Foreign Trade and Competitiveness Act of 1987,  but the President vetoed the bill, and a vote to override the veto failed in the Senate. (See  H.R. 3, 100th Cong. (1987). S. 1420 was incorporated into H.R. 3.) The provision limiting  the concept of “personal-use quantities” to airports was in the Omnibus Foreign Trade and  Competitiveness Act of 1988, which Congress passed and the President signed. Pub. L.  No. 100-418, § 1908(b), 102 Stat. 1107, 1316.

At Commerce, Census is responsible for collecting, compiling, and  publishing export trade statistics. AES is the primary instrument for  collecting export trade data. Census takes steps to ensure  compliance by AES filers, including duty-free store operators, through  training and follow-up on unusual transactions, according to Census  officials.

At DHS, CBP and ICE are the components with roles related to duty- free cigarette exports.

CBP is responsible for oversight of duty-free stores, including the  requirements for establishment of stores and ensuring stores’  compliance with various requirements for operations and lawful  sales. Duty-free stores are regulated as a type of bonded  warehouse. CBP port directors ensure that duty-free stores  establish operating procedures. According to CBP officials, the  agency is also responsible for enforcing the Foreign Trade  Regulations, including consideration of enforcement action when  an AES filer submits incorrect information regarding a shipment of  merchandise being exported.  Such enforcement action may  include the issuance of penalties or the seizure of the  merchandise intended for export.

ICE enforces U.S. laws related to tobacco smuggling for cases in  which it has investigative jurisdiction, including related offenses  such as money laundering. According to agency officials, ICE also  coordinates with CBP on enforcement efforts, such as seizures of  merchandise due to violations of U.S. laws or customs  regulations.

At DOJ, ATF investigates trafficking in cigarettes that have illegally  entered U.S. commerce and enforces federal antitobacco smuggling  laws under Title 18 of the U.S. Code, particularly the Prevent All  Cigarette Trafficking Act and Contraband Cigarette Trafficking Act  (CCTA).17 As we previously reported, by enforcing the CCTA, ATF  seeks to reduce illegal cigarette trafficking, divest criminal and terrorist  organizations of money derived from this activity, and significantly  reduce tax revenue losses to the affected states.

At Treasury, TTB is responsible for administering and enforcing the  federal tax laws relating to tobacco products. Federal law requires that  every person, prior to commencing business as a manufacturer or  importer of tobacco products or establishing a TTB-regulated export  warehouse for the storage of nontax-paid tobacco products pending  export, obtain a permit from TTB. According to TTB officials, among  the regulations that TTB enforces are those governing the export of  tax-exempt tobacco products, under which only tobacco product  manufacturers and export warehouse proprietors may remove  tobacco products for export without payment of tax. TTB officials  also stated that a manufacturer of tobacco products or an export  warehouse proprietor is relieved of the liability for tax on tobacco  products upon providing evidence satisfactory to TTB of exportation or  proper delivery, including delivery to a customs bonded warehouse  operating as a duty-free facility. TTB may audit TTB permit holders to  confirm such deliveries or exports.

See Prevent All Cigarette Trafficking Act of 2009, Pub. L. No. 111-154, 124 Stat. 1087  (2010) and Contraband Cigarette Trafficking Act, Pub. L. No. 95-575, 92 Stat. 2463 (1978)  (codified as amended at 18 U.S.C. §§ 2341-2346). The Contraband Cigarette Trafficking  Act makes it unlawful (a felony) for any person to ship, transport, receive, possess, sell,  distribute, or purchase contraband cigarettes. Contraband cigarettes are cigarettes in a  quantity of more than 10,000 sticks (currently, 50 cartons) that bear no evidence of  applicable state or local cigarette tax payment in the state or locality in which the  cigarettes are found, if such state or local government requires a stamp or other indicia to  be placed on the packages or other containers of cigarettes to evidence payment of  cigarette taxes and which are in the possession of any person other than specified  persons, including permit holders under the Internal Revenue Code, common carriers  transporting cigarettes with proper bills of lading, or individuals licensed by the state where  the cigarettes are found.

Purchasers and Exporters of Duty- Free Cigarettes at the Southwest Border Are Subject to U.S. and Mexican Requirements; Agencies Identified Schemes and Practices That Facilitate Illicit Trade

Duty-free stores may sell tax-exempt cigarettes in any quantity to  passengers departing the United States for Mexico at a port on the land  border; agencies have identified schemes and practices associated with  duty-free sales that are used to evade U.S. and Mexican taxes. U.S.  regulations require duty-free stores to have procedures to provide  reasonable assurance that duty-free merchandise sold will be exported  and requires the exporter to report information on the export of  commercial cargo, which CBP considers to be transactions valued at  more than $2,500. Census data indicate that about 18,500 such  transactions occurred from 2010 through 2015 at duty-free stores on the  southwest border. According to information from CBP and a Mexican  customs official, Mexican requirements dictate that, depending on place  of residence, some adult travelers to Mexico can bring in one carton of  cigarettes tax-exempt, and some residents can bring in an additional  three cartons if they pay taxes on them. Bringing in any quantity above  four cartons would require an individual to register as an importer with the  Mexican government, according to the same Mexican official. U.S.  agencies identified three schemes used to evade cigarette-related taxes  and other legal requirements in the United States and Mexico:  (1) diverting cigarettes from the store directly into U.S. commerce; (2)  smuggling duty-free cigarettes into Mexico through U.S. ports of entry by  concealing them, while potentially also bribing Mexican customs officials  to evade payment of Mexican taxes; and (3) smuggling duty-free  cigarettes back into the United States after first smuggling them into  Mexico.

U.S. Regulations Require Duty-Free Stores on the Southwest Border to Provide Reasonable Assurance of Export of Cigarettes and Report Transactions Over $2,500

Duty-Free Stores Sell Tax- Exempt Cigarettes to Passengers Departing the United States

Cigarettes manufactured in the United States and labeled for export may  be shipped, without payment of federal or state tax, to duty-free stores for  export and consumption beyond the jurisdiction of U.S. internal revenue  laws. In addition to U.S.–manufactured cigarettes, duty-free stores can  sell cigarettes imported from overseas. Duty-free cigarettes, which are  cigarettes labeled for export, are considered to be in violation of U.S. law  if sold for domestic consumption in the United States.24 According to CBP  officials, in the duty-free retail environment, the individual purchasing the  merchandise is the exporter.

Cigarettes sold at duty-free stores are generally distributed to duty-free  retail outlets from warehouses maintained by the duty-free operator.  Figure 2 outlines potential steps in the lawful export of duty-free  cigarettes, according to U.S. and Mexican agency officials.

Tobacco products manufactured in the United States and labeled for exportation may  not be sold or held for sale for domestic consumption in the United States unless such  articles are removed from their export packaging and repackaged by the original  manufacturer into new packaging that does not contain an export label. 26 U.S.C. §  5754(a)(1)(C).

Duty-Free Stores at the Southwest Border Must Provide Reasonable Assurance of Export of Cigarettes to Mexico

CBP requires duty-free stores to have procedures designed to provide  reasonable assurance that duty-free merchandise is exported.25 For duty- free stores along the southwest border, such procedures are designed to  ensure export by pedestrians and passengers in vehicles crossing into  Mexico. The four operating procedures for duty-free stores that we  reviewed require that they assure that individuals and their merchandise  depart the United States for Mexico under escort or observation.

Figure 3 shows the procedures at a duty-free store in Laredo, Texas, that  is located at the border. This duty-free store sells cigarettes from a drive- through window; at the time of purchase, a store employee puts a  numbered red cone on the roof of the vehicle. A private security guard  employed by the duty-free store removes the red cone at the border  crossing to verify that the vehicle exits the United States. In other ports,  duty-free stores may be located farther from the U.S. border crossing,  and the procedures designed to assure export of duty-free goods could  entail having a store employee in a van or other vehicle escort purchasers  to the crossing. According to the procedures of one duty-free store we  visited, refusal by a pedestrian customer to cross into Mexico should  typically result in that customer returning to the store and being given a  refund for the duty-free goods purchased, and if the customer refuses to  return to the store for a refund and does not cross into Mexico, that  individual is not allowed to purchase in the facility again. In the case of a  customer in a vehicle, the store should notify CBP, and that customer  should not be allowed to purchase in that facility again.

U.S. laws and a customs regulation stipulate that duty-free stores shall establish  procedures to provide reasonable assurance that duty-free merchandise sold by the store  is exported. 19 U.S.C. § 1555 and 19 C.F.R. § 19.36. Customs regulations further specify  conditions for delivery of such items at land border locations, meaning an exit point from  which individuals depart to a contiguous country by vehicle or on foot by bridge, tunnel,  highway, walkway, or by ferry across a boundary lake or river. 19 C.F.R. § 19.39.

Duty-Free Cigarette Transactions Valued at More Than $2,500 Are Subject to Reporting; Operators of Duty- Free Stores Reported About 18,500 Such Transactions in 2010–2015

For every duty-free store transaction in which the value of the goods is  more than $2,500, the Foreign Trade Regulations generally require that  the U.S. principal party in interest (USPPI) or its agent file electronic  export information through AES. (In this report, we use “exporter” to refer  to the USPPI.) According to CBP officials, this requirement extends to  purchases of duty-free cigarettes. The export information includes 28  mandatory data elements such as the value, quantity, name of exporter,  name of the person receiving the shipment, and method of transportation.  AES data from Census showed a total of 18,504 such transactions from  2010 through 2015 from duty-free stores on the southwest border, with  almost 70 percent exported from Texas (see fig. 4 and table 1). The  number of duty-free cigarette transactions valued at over $2,500 peaked  in 2012 at 4,685 and declined to a level about 45 percent lower in 2014  and 2015. According to CBP officials in Laredo and the San Diego area,  while it is not possible to determine the exact cause, duty-free stores may  have reported greater numbers of these transactions in 2012 due to an  increase in enforcement actions at those ports that encouraged greater  compliance with export data filing requirements. These officials said  stores may have reported fewer transactions valued at over $2,500 in  subsequent years due to CBP’s continued enforcement actions. CBP  officials said that they have no way of systematically knowing the full  scale of exports that occur through transactions valued at under $2,500.  Those transactions are not captured in data that are required to be  reported to the U.S. government.

Mexican Customs Regulations Limit the Amount of Cigarettes Individuals Crossing the Southwest Border May Bring with Them

According to information provided by officials from CBP and the Mexican  customs agency, Mexican residents above the age of 18 are allowed to  bring up to four cartons of cigarettes into Mexico, depending on where  they live. Specifically, officials from CBP and the Mexican customs  agency provided the following details:

The Mexican customs agency allows each adult who is a resident of  the interior of Mexico (not living in towns adjacent to the border)  crossing from the United States to bring up to four cartons of  cigarettes into Mexico; the first would be exempt from Mexican taxes,  and the remaining three would be taxed at a 573-percent rate.

Mexican border-zone residents, defined as those who live in towns  along the U.S.-Mexico border such as Ciudad Juarez and Tijuana, are  subject to different rules and are not permitted to bring cigarettes into  Mexico.

A Mexican customs official said that bringing in any quantity of cigarettes  above these amounts would require an individual to register as an  importer with the Mexican government, including both the customs  agency and health ministry, and obtain a health authorization in advance  of the importation. This official also said that commercial cigarettes are  charged a 67-percent import duty, a 16-percent value-added tax, and  other special duties or taxes that may be applicable.

U.S. Agencies Identified Three Schemes and Related Purchasing Practices by Which Duty- Free Cigarette Traffickers Evade Taxes in the United States and Mexico

For purposes of this report, we use “divert” and “diversion” to refer to the unlawful  introduction of duty-free cigarettes into U.S. commerce using a scheme that does not  involve the crossing of the southwest border. We use “smuggle” and “smuggling” to refer  to the surreptitious exporting or importing of duty-free cigarettes that involves the crossing  of an international border.

Diverting Duty-Free Cigarettes Directly into the United States

In this scheme, cigarettes are purchased from a land border duty-free  store and diverted into the United States without paying applicable taxes.  According to ICE officials, individuals diverting cigarettes use methods  that include bribery of a duty-free store official to allow a vehicle to stay in  the United States without informing CBP instead of observing its crossing  into Mexico. CBP and ICE officials also reported instances of individuals  loading cigarettes into a car after the duty-free store had closed. CBP  officers in the San Diego area also identified the following deceptive  practices in the course of a 2010 operation, some of which were carried  out with the complicity of store employees who took actions such as escorting vehicles using unapproved exit routes, allowing purchasers of large quantities to leave the store unescorted, assisting purchasers in their efforts to conceal goods in the door  panels and engine compartments of their vehicles.

In April 2013, ICE received information of a pending large purchase of  cigarettes from a duty-free store in Nogales, Arizona. ICE agents were  surveilling the store when they observed an individual loading cigarettes  into a van and leaving without an escort from the store. The van did a U- turn just before reaching the crossing into Mexico. ICE seized 840 cartons  of cigarettes purchased from a duty-free store after pursuing the van in  which the purchaser drove north away from the border into the United  States instead of traveling across the border into Mexico.

Smuggling Duty-Free Cigarettes into Mexico across the Land Border, Contrary to That Country’s Laws

In this scheme, according to CBP and ICE officials, individuals legally  purchase cigarettes from duty-free stores in the United States and  smuggle them into Mexico through U.S. ports of entry by concealing  these goods in their vehicles or on their person. The individuals may  attempt to bribe Mexican customs officials to evade payment of Mexican  taxes, according to CBP and ICE officials.

CBP and ICE officials reported that they observed individuals in the  parking lots of duty-free stores near the port of San Diego loading  cigarettes into concealed compartments in personal vehicles to smuggle  them into Mexico. An ICE officer in California told us that smugglers had  posted Internet advertisements online to recruit runners to move  cigarettes across the border from the United States. ICE officials provided  data that they obtained from the government of Mexico on cigarette  seizures its officials conducted from 2012 through 2015 at numerous  locations along the border, including entry points in Mexico directly  opposite El Paso, Texas, and San Diego, California, as well as in other  parts of Mexico. The data indicate that the Mexican government seized  1.2 million cartons of cigarettes in 2012; the number of cartons seized  steadily decreased to about 320,000 cartons in 2015. At least one of the  brands among those seized is associated with the operator of multiple  duty-free stores on the southwest border. (See fig. 6 for photographs of  duty-free cigarettes concealed in vehicles and discovered by Mexican  customs officials.)

CBP officials in Laredo told us that they had conducted joint operations  with Mexican officials at the passenger crossings but that counter  surveillance by smugglers often limited their effectiveness. Typically, a  short time after initiating an operation, they would observe that smugglers  had ceased activities temporarily and that every vehicle CBP officers  examined contained only one or two cartons of cigarettes, an amount  that, according the CBP officials, complies with Mexican import  restrictions.

Smuggling Duty-Free Cigarettes Back into the United States after First Smuggling Them into Mexico

In this scheme, duty-free cigarettes that are smuggled into Mexico are  brought back across the border and introduced into U.S. commerce  without declaring the goods to CBP upon reentry, thus avoiding relevant  U.S. taxes. Smugglers might bring these goods back into the United  States in small amounts, to avoid detection, and take them to rented  storage facilities along the border, according to CBP officials at the port of  San Diego. The smuggled cigarettes are bundled into larger quantities  and subsequently transported for sale at locations in the interior of the  United States. During our fieldwork at the port of San Ysidro, CBP  officials identified warehouses where such cigarettes had been stored in  the past.

Traffickers Can Facilitate Diversion and Smuggling by Avoiding the $2,500 Threshold for Reporting Transactions or by Moving to Another Port

According to agency officials, traffickers engaged in diversion and  smuggling schemes minimize their visibility to the U.S. government by  dividing a large purchase of duty-free cigarettes into smaller ones to avoid  the AES reporting threshold of $2,500. Such structured transactions can  be carried out by individual buyers or by multiple individuals making  purchases on behalf of the holder of an account at a duty-free store. As  part of a 2012 enforcement operation, CBP officials reviewed receipts for  cigarette sales from three duty-free stores in San Ysidro and identified six  people who made multiple purchases during the same day at one of the  stores. One of these six individuals made 14 consecutive purchases of  cigarettes valued at $200 and then a final purchase of $100 for a total of  $2,900 which, as a single transaction, would have exceeded the $2,500  threshold for reporting such exports. In addition, CBP officials in Laredo  described a 2010 scenario in which U.S. citizens moved $100,000 worth  of tobacco products into Mexico over the course of a month by making  repeated crossings on foot with under $2,500 in merchandise each time  so that no reporting was required. Further, CBP officials at the port of San  Diego said that following a series of CBP operations related to duty-free  stores from 2010 through 2012, they reviewed the stores’ sales records  and noticed a decrease in high-value sales. An ICE official said, however,  that cigarette smuggling operations may have moved eastward in  response to CBP operations in California. In addition, according to these  CBP officials, a 2010 operation discovered multiple store operators  maintaining two sets of accounts to link cash outlays upfront for multiple  purchases.

Smuggling of Duty- Free Cigarettes across the Southwest Border Is Reportedly Linked to Organized Crime and Supplies the Illicit Tobacco Market in Mexico; U.S. Efforts to Counter This Illicit Activity Face Challenges

U.S. agency officials said that some smuggling of duty-free cigarettes  across the southwest border has links to organized crime, supplies the  illicit tobacco market in Mexico, and poses oversight challenges. ICE  officials told us that transnational criminal organizations use smuggled,  duty-free cigarettes to launder money and generate revenue.  Furthermore, a Mexican customs official noted that relatively inexpensive  cigarettes manufactured in the United States, which cannot legally be  sold in the United States or in Mexico, are routinely sold for export from  duty-free stores on the southwest border; such cigarettes are then  smuggled across to supply Mexico’s illicit tobacco market. One brand of  such cigarettes has been cited in recent studies as a significant part of  the illicit tobacco trade in Mexico. U.S. officials reported that their efforts  to counter the illicit movement of duty-free cigarettes face challenges  related to the purchaser’s ability to buy duty-free cigarettes in unlimited  quantities and to use passenger, not commercial, crossings from the  United States into Mexico. According to U.S. officials, while U.S.  agencies do not have the authority to seize exports that violate Mexico’s  laws related to these cigarettes, U.S. officials reported working with  Mexican officials on activities to enforce the customs laws and regulations  of both countries.

Criminal Organizations Reportedly Use Duty-Free Cigarettes to Launder Money and Generate Revenue

The term “black market” refers to trade in goods or commodities in violation of laws and  regulations. method of generating funds. In addition to U.S.– manufactured  cigarettes, foreign cigarettes are also smuggled into Mexico.

According to ICE officials, transnational criminal organizations launder  money by depositing illicit funds into client accounts at duty-free stores  along the southwest border. They then make withdrawals from these  accounts, just as they would from a bank account, to purchase duty-free  tobacco and alcohol.37 According to ICE officials, transnational criminal  organizations purchase in quantities such that some duty-free stores give  them substantial discounts on the stores’ in-house cigarette brands.  Subsequently, these goods are smuggled either by concealment or  bribery of Mexican customs officials, according to ICE officials. According  to an official from the Mexican customs agency, some drug cartels add  their own product identification codes onto packs of cigarettes from duty- free stores for sale in areas that they control.

Certain Duty-Free Cigarettes from the United States Comprise a Large Share of the Illicit Mexican Market

ICE defines trade-based money laundering as the use of trade to legitimize, conceal,  transfer, and convert large quantities of illicit cash into less conspicuous assets. ICE  officials in San Diego explained that, in Southern California, criminals use other  commodities more frequently than cigarettes for trade-based money laundering.

According to a public health warning issued by a federal commission of the Mexico  health secretariat, this particular brand of U.S.-made cigarettes for duty-free sale is among  those cigarettes “which can be counterfeit, adulterated, and even made with unknown  ingredients, increasing the possibility that they contain potentially toxic non-tobacco  chemicals.” the illicitly trafficked cigarettes that the Mexican government confiscated  at various locations in the country from 2012 through 2015. In addition, in  2013, the Mexican customs agency executed a number of seizures of this  brand of duty-free cigarettes that were undeclared at ports of entry on the  U.S.-Mexico border (see fig. 7).This brand of cigarettes has been cited in  recent studies as a significant part of the illicit tobacco trade in Mexico.

ICE officials provided a November 2015 report issued by the National  Cyber-Forensics & Training Alliance, a public-private partnership,  which stated that this U.S.-made brand of cigarettes was recognized  as the largest illegal brand being sold in Mexico. The report also  stated that this brand of cigarettes was being diverted into Mexico  through various duty-free stores in Laredo, Texas, and San Diego,  California.39

Another study reported that, as of June 2014, 64 percent of the inflow  of tobacco into Mexico from the United States consisted of this brand  of cigarettes manufactured and trademarked in the United States and  sold at duty-free stores on the southwest border. The study also  noted that this brand of cigarettes accounted for about 13 percent of  the overall illicit cigarette market in Mexico.

National Cyber-Forensics & Training Alliance (NCFTA), Southern Border Illicit Tobacco  Activity (Pittsburgh, Penn.: November 2015). The NCFTA is funded by private sector  entities, including tobacco firms. ICE has a partnership agreement with the NCFTA and  assigns agents there through the National Intellectual Property Rights Coordination Center  that it leads.

Mexico and that they did not have an obligation to know since the  company is not the exporter of the cigarettes.

U.S. Officials’ Efforts to Counter Illicit Trade in Duty-Free Cigarettes Face Challenges

Agencies Cite the Ability to Buy Unlimited Quantities of Duty- Free Cigarettes at the U.S. Land Border as a Factor That Facilitates Smuggling

CBP and ICE officials in Laredo said that the ability to buy unlimited  quantities of duty-free cigarettes at the land border facilitates large  shipments of these goods to be clandestinely smuggled into Mexico. CBP  officials acknowledge that duty-free stores on the southwest border are  functioning as wholesale suppliers of cigarettes. During congressional  consideration of duty-free store legislation, a senator raised the issue of  the potential for economic harm to communities adjacent to the U.S.- Mexican border if a provision precluding duty-free sales in wholesale  quantities were applied to land border stores. Congress later enacted  the Omnibus Foreign Trade and Competitiveness Act of 1988, which  required duty-free stores located in airports to restrict the sale of duty-free  merchandise to any one individual to “personal use quantities,” a  requirement that does not apply to land border stores. According to CBP  officers in San Diego, duty-free store representatives told them in 2010  that the stores at the port of San Ysidro were some of the most profitable  in the country and that merchandise sold in wholesale quantities was an  important part of their business.

Use of Passenger Crossings to Export Large Quantities of Duty-Free Cigarettes Creates Oversight Challenges; CBP Officials Said They Are Reviewing Proposed Options at One Port

U.S. officials said that the ability to use passenger crossings to export  wholesale quantities of duty-free cigarettes enables these goods to enter  Mexico with less scrutiny and oversight than if they were processed  through a commercial crossing. U.S. ports on the land border may have  multiple crossings, some designated for passenger traffic and others for  commercial traffic. CBP officials said that duty-free cigarettes are treated  as noncommercial goods that exit via passenger crossings and, therefore,  are not subject to the same requirements and potential for CBP oversight  as commercial exports. Requirements for commercial cargo leaving the  United States include submission of electronic information to CBP in  advance of departure. CBP and ICE officials in Laredo noted that CBP  does not define what constitutes a commercial export, enabling the use of  passenger crossings by purchasers of “commercial-type” quantities.45  CBP officials in Laredo and San Diego said that individuals purchasing  large quantities of duty-free cigarettes would likely be less able to evade  Mexican taxes if the goods were to exit from a commercial crossing.

Officials said that CBP-enforced regulations also do not provide a definition for what  would constitute a commercial quantity and that the agency has not adopted its own  definition or guidelines in part because commercial transactions can have different  quantities and varying price points. CBP officials said that they view commercial exports to  be merchandise for business resale or for profit, rather than for individual use, such as for  personal or household consumption.

In the San Diego area, which has one of the highest concentrations of  duty-free stores among ports on the southwest border and has multiple  crossings into Mexico, CBP took steps to try and address the challenge  of large quantities of duty-free cigarettes moving through passenger  crossings. In 2010, CBP in San Diego prepared a draft notice for  members of the area trade community, including duty-free stores,  announcing that the Port Director had decided more controls were  necessary to ensure the export of duty-free merchandise purchased for  resale. The draft notice identified four scenarios that would meet the  definition of a commercial purchase and identified appropriate exit  procedures for any commercial purchases to include exit from a  commercial (or cargo) export facility, instead of from the passenger  crossing. In July 2017, CBP officials indicated that no change in exit  procedures for duty-free tobacco products had taken place; previously,  they had stated that CBP had not issued the notice because it was still  undergoing review. Officials at CBP headquarters in Washington, D.C.,  informed us that the agency was planning to engage with port officials in  San Diego to plan appropriate next steps in assessing the type of  crossing through which duty-free cigarettes should be exiting.

U.S. Agency Officials Report That They Are Not Authorized to Seize Exports That Violate Mexico’s Laws but Have Taken Steps to Work with Mexico on Enforcement

CBP officials said the agency does not have the authority to seize goods  that are being smuggled into Mexico contrary to that country’s laws.  Officials at CBP headquarters said that enforcing Mexican laws is not the  responsibility of U.S. agencies, but officials at two different ports of entry  also described efforts to work with Mexican counterparts on activities  related to enforcing customs laws and regulations of both countries. In  addition, CBP in Laredo instructed duty-free store operators to discourage  customers from concealing duty-free items by including procedures about  this in their employee manuals. We reviewed the procedures manual for  one of these operators and found that it directed employees to inform  customers that they were not allowed to hide or conceal duty-free items.

CBP and ICE officials told us they are able to take some actions in  concert with their Mexican counterparts related to coordination and  information sharing at both the border and headquarters levels.  Specifically, CBP officials in Laredo told us that they conduct joint  enforcement operations with Mexican officials to inspect passenger  vehicles as they exit the United States and enter Mexico. ICE and CBP  officials in Laredo also said that the issue of cigarette smuggling has been  raised at bilateral security cooperation meetings that are routinely held  with Mexican customs and law enforcement counterparts. Additionally,  according to officials there, ICE’s National Intellectual Property Rights  Coordination Center, under terms of the U.S.-Mexico Customs Mutual  Assistance Agreement, has obtained information from the Mexican  customs agency on that country’s seizures of cigarettes nationwide to  advance related investigations in the United States. An ICE official said  that the agency has also worked concurrently with its counterparts in  Mexico to advance an investigation related to the smuggling of cigarettes  from U.S. bonded warehouses that were destined for duty-free stores but  were being smuggled directly into Mexico and possibly diverted back into  the United States. According to the ICE official, ICE has continued to  keep Mexico abreast of developments through its attaché in Mexico City.

Selected Export Data Reported by Duty- Free Stores Show Irregularities, Which CBP Has Taken Some Steps to Address

Multiple Duty-Free Stores Are Filing Some Noncompliant Information on Cigarette Exports

According to CBP, in many cases duty-free stores on the southwest  border are filing some noncompliant information that they are required to  report on cigarette exports valued at more than $2,500. Our analysis of  export data from Census also showed that many transactions include  some noncompliant information. Specifically, we identified the following  three compliance issues:

According to CBP, in most instances, the duty-free store should  identify the purchaser of the cigarettes as the exporter, and  subsequently, report the purchaser’s name and also provide a unique  numerical identifier for the purchaser such as a passport or border  crossing card number. In our analysis of reported data for 18,504  transactions involving cigarettes at duty-free stores on the southwest  border from 2010 through 2015, we found that 99 percent of these  transactions indicate that the duty-free store operator sold the  merchandise to an individual purchaser but identified itself as the  exporter through use of its Internal Revenue Service employer  identification number (EIN). According to CBP officials, these  transactions pose potential compliance concerns.

Duty-free stores on the southwest border owned by one operator  commonly used the operator’s postdeparture filing privilege for  cigarette transactions while also reporting them as routed export  transactions. However, the Foreign Trade Regulations specify that  postdeparture filings cannot be made for routed export transactions.  This duty-free store operator incorrectly used its postdeparture filing  privilege and marked transactions as routed exports in 16,384 of the  16,387 transactions it reported during 2010 through 2015.

In response to our inquiries, CBP reviewed AES filings for this duty- free store operator and found additional compliance concerns related  to filings showing Otay Mesa, California, as the port of exit.  Specifically, according to CBP, the duty-free store operator was filing  information indicating that the cigarettes were leaving the country  through the port of Otay Mesa, although CBP officials had previously  observed the sales leaving through the port of San Ysidro, California.

CBP Has Provided Information to One Duty- Free Store Operator Reporting Inaccurate Data on Cigarette Transactions but Has Not Taken Steps to Finalize Any Guidance

CBP has acted to address its compliance concerns with one duty-free  store operator, but other possible actions remain, including the issuance  of final instructions and guidance to all operators on the border and the  public. According to CBP, one of the ways it fosters adherence to rules  and regulations in the trade community is through “informed compliance,”  the idea that, in order to maximize voluntary compliance with trade laws  and regulations, the trade community needs to be clearly and completely  informed of its legal obligations. We have previously found that  information programs are a key part of CBP’s informed compliance  strategy at both headquarters and the ports. For example, CBP issues  directives, handbooks, and a series of “informed compliance publications”  that provide guidance on various trade-related matters.

In 2012, CBP informed the duty-free store operator with the largest  number of AES transactions we reviewed that its transactions incorrectly  identified its stores as the exporter when in fact the purchaser was the  exporter. Regulations state that knowingly failing to file or knowingly  submitting false or misleading export information through AES is a  violation subject to penalties. CBP is authorized to enforce the Foreign  Trade Regulations, which include regulations on reporting through AES.  With regard to the compliance issue that CBP raised in 2012, CBP did not  take action until after April 2014, when a CBP assessment of export  transactions found that the problem with the operator’s cigarette export  filings continued. In August 2014, CBP issued a penalty to the duty-free  store operator, and the operator requested that CBP give it time to arrive  at an agreement with the agency and remove the penalty, noting that a  change to current practices might have adverse consequences on its  business and further emphasizing that its practices had been widely  known for years. According to CBP officials, due to the operator’s  confusion over correct procedure, the penalty was canceled, and officials  decided to take steps to ensure proper filing of AES through informed  compliance.

In October 2015, CBP provided the operator with interim instructions on  how to comply with its requirements under the Foreign Trade  Regulations. Those instructions included scenarios illustrating both  compliant and noncompliant export data filings for transactions involving  cigarettes. CBP officials also told us that a planned meeting with the  duty-free store operator to finalize instructions never took place and that  CBP never provided final instructions to that operator.

According to CBP officials, this duty-free store operator continues to  identify itself as the exporter and to use its postdeparture filing privilege.  CBP officials said that duty-free stores assert that they are working to be  compliant, but it is challenging for them in part because the cigarette  purchasers are often unaware of their role and do not have accounts  established to file the electronic export data. Additionally, one CBP official  said that purchasers may be reluctant to provide a verifiable numeric  identifier, such as a passport number or border crossing card, if they are  involved in smuggling operations. Furthermore, CBP and ICE officials  said that employees working at land border duty-free stores may not be  fully trained and aware of proper filing procedures.

In response to our inquiries, Census re-sent the 2015 interim instructions  to the duty-free store operator in March 2017, after confirming that the  operator was still using its postdeparture privilege when it should not.  CBP officials indicated in July 2017 that they plan to conduct outreach to  duty-free stores on the southwest border and provide guidance to the  ports there to ensure proper data submission and appropriate use of  postdeparture filing. CBP headquarters officials informed us that they had  recently held initial discussions on this topic with agency officials in  Laredo, but they had not issued any further information to the duty-free  store operators and to the public; they said further discussions were  planned. CBP officials did not identify instances of providing similar  information to, or having discussions with, the other duty-free store  operators.

The Foreign Trade Regulations state that the filer of export information in  AES is responsible for transmitting accurate data as known at the time of  filing. An ICE official said that properly completed export data with  purchasers’ verifiable identification numbers would allow ICE to  corroborate that information against other databases, such as the  Automated Targeting System (ATS), during an investigation. ATS  compares traveler, cargo, and conveyance information against law  enforcement, intelligence, and other enforcement data to assess risk. In  addition, ICE sought data from Mexico, such as names and dates of birth  of individuals arrested in connection with cigarette seizures in that  country, to keep that information on file in the event the individuals were  associated with cases in the United States. Agency officials said that  verifiable identification information, such as the type that is collected in  AES filings, would further help ICE corroborate and identify individuals  participating in the illicit trade of duty-free cigarettes. CBP officials said  that accurate data on the identity of the exporter would benefit law  enforcement and intelligence operations. Without accurate data, including  correct and complete information on the exporter, agencies may lack the  information they need to enhance their enforcement and intelligence  efforts related to the illicit trade of duty-free cigarettes on the southwest  border.

Unlike duty-free stores at U.S. airports, duty-free stores associated with  U.S. land borders may sell tax-exempt cigarettes in any quantity. Since  Congress legislatively adopted this policy in 1988, changes on both the  U.S. and Mexican sides of the southwest border have affected this trade.  Agencies have cited a number of schemes used by individuals to divert  these products into Mexico and into U.S. commerce, despite efforts by  CBP to enforce relevant regulations and procedures. Agencies have  noted that, as smuggling has become potentially more lucrative, an  existing linkage may grow stronger between cigarette smuggling and  organized crime on the southwest border, where they believe that criminal  organizations have created distribution networks to illicitly move  cigarettes in both countries. CBP officials also state that the agency does  not have the authority to seize goods that are being smuggled into Mexico  contrary to that country’s laws.

CBP has made efforts to utilize available data collected on transactions  valued at over $2,500 to evaluate duty-free store compliance with  regulations. However, despite various outreach and enforcement efforts,  agency officials said that inaccurate filings by one large operator— comprising nearly 89 percent of the transactions we reviewed—continue,  and other store operators are still potentially out of compliance. Until  steps are taken to ensure that duty-free store operators and exporters  fully comply with reporting requirements, U.S. agencies will lack the  accurate, complete information that can help them conduct their  enforcement and intelligence efforts.

The Commissioner of the U.S. Customs and Border Protection should  take steps to strengthen compliance with export reporting requirements  related to duty-free cigarette sales on the southwest border, such as  issuing guidance to all duty-free store operators. (Recommendation 1)

We provided a draft of this product to Commerce, DHS, DOJ, and  Treasury for comment. DHS provided substantive comments that are  reproduced in appendix III. Commerce and DHS also provided technical  comments, which we incorporated as appropriate. DOJ and the Treasury  provided no comments.

In its comments on our draft report, DHS concurred with our  recommendation. DHS stated that CBP’s Office of Field Operations will  issue guidance and engage field personnel to strengthen compliance with  export requirements. In addition, DHS stated that ports would be  instructed to provide guidance to all duty-free store operators on correct  filing procedures for electronic export information (EEI), including use of  the correct port of export and identifying the party responsible for filing the  EEI. DHS gave an estimated completion date for these actions of October  31, 2017.

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If you or your staff members have any questions about this report, please  contact me at (202) 512-3149 or gootnickd@gao.gov. Contact points for  our Offices of Congressional Relations and Public Affairs may be found  on the last page of this report. GAO staff who made key contributions to  this report are listed in appendix IV.

Appendix I: Objectives, Scope, and Methodology

This report examines (1) requirements that govern the lawful sale and  export of cigarettes from duty-free stores on the southwest border and  schemes for illicit trade in such cigarettes that agencies identified, (2)  U.S. agency observations about these duty-free cigarette exports and  efforts to counter illicit trade, and (3) the extent to which selected cigarette  transaction data submitted by duty-free stores indicate compliance issues  with reporting requirements.

To obtain background information on duty-free stores, we reviewed  documents related to the legislative history of duty-free stores, including  those from the Congressional Record and U.S. laws and customs  regulations. To describe relevant agency roles related to duty-free  cigarette exports, we reviewed documents from the agencies and utilized  information from interviews with their officials.

To address the first two objectives, we collected and analyzed information  through several methods. We reviewed relevant federal laws and  regulations. We also interviewed officials from the Department of  Commerce’s U.S. Census Bureau (Census); the Department of  Homeland Security’s U.S. Customs and Border Protection (CBP) and  U.S. Immigration and Customs Enforcement (ICE); the Department of  Justice’s Bureau of Alcohol, Tobacco, Firearms, and Explosives; the  Department of the Treasury’s Alcohol and Tobacco Tax and Trade  Bureau; and tax-collection officials from the state of California. We also  interviewed representatives from private sector tobacco and duty-free  firms. We conducted field work in California in the areas around San  Diego, including Otay Mesa and San Ysidro, and Los Angeles. We  selected these locations based on the presence of duty-free stores or  reports of cigarettes being diverted from duty-free stores into the United  States, supplemented by insights from agency officials. We also used  information gathered from field work in Laredo, Texas, that we conducted  under a related review. We spoke with U.S. agency officials in Nogales,  Arizona, and in the Washington, D.C., area. Lastly, we spoke with and  obtained data from an official from the Mexican customs agency, the Tax  and Customs Administration Service.

To describe how cigarettes are sold and exported from duty-free stores  on the southwest border, we also reviewed relevant U.S. laws and  customs regulations and collected information from U.S. and Mexican  officials on allowances and requirements for duty-free cigarettes imported  into Mexico. In addition, to describe the views that agency officials have  expressed with regard to cigarette exports from duty-free stores on the  southwest border, we reviewed CBP documents that described operating  procedures at the ports of Laredo, Texas, and San Diego, California; a  draft port information notice from the port of San Diego; and reports from  the private sector and a public-private partnership, the National Cyber- Forensics & Training Alliance, on the illicit tobacco market in Mexico. We  also analyzed data on seizures from the Mexican Tax and Customs  Administration Service and information from interviews with officials from  CBP, ICE, and the Mexican government.

We also analyzed Automated Export System (AES) data from Census for  2010 through 2015 on recorded transactions at the duty-free stores CBP  identified as being adjacent to the U.S.-Mexico border, also referred to as  the southwest border, spanning Texas, New Mexico, Arizona, and  California. We determined that value and quantity data for those  transactions were not reliable for the purposes of this report; we based  our assessment on a review of related documentation and on interviews  with Census officials about the agency’s procedures to ensure the quality  of the data and with CBP officials to discuss relevant aspects of how  transaction data might be entered in AES. According to Census officials, it  is not possible to identify from AES whether or not an export came from a  duty-free store, as such information is not required when filers submit  electronic export information. We used an alternative method to identify  the AES data associated with transactions at duty-free stores on the  southwest border: We obtained the employer identification numbers (EIN)  for those duty-free stores from CBP, which identified 88 duty-free stores  on the southwest border that in some cases used the same EIN because  some stores owned by the same proprietor used the same EIN. We  obtained 54 EINs covering the 88 border stores. In one instance, a single  EIN applied to 7 duty-free stores.

Census provided us with the export transactions recorded in AES that  corresponded to the 54 EINs provided by CBP. Census protects the  confidential data contained in export transaction records it receives from  firms but may disclose the data to other government agencies if the  agency determines it is in the national interest to do so. For each  transaction record, we requested the data for 24 of the 28 mandatory  fields in AES for which exporters must provide information. In addition,  we asked Census to filter the information by several fields to include  country of destination (Mexico) and the Harmonized Tariff Schedule  codes associated with cigarettes. Census identified 19,101 transaction  records in response to our request. After removing those records that fell  outside of our parameters (e.g., entries from 2009 and entries for which  the value was $2,500 or less), 18,504 export transaction records  remained. To identify the schemes related to the illicit trade in duty-free  cigarettes, we reviewed court documentation from criminal cases at the  state and federal levels. We also reviewed Federal Register notices for  historical references to cases of smuggling in addition to interviewing  officials from the U.S. and Mexican governments.

To evaluate the extent to which duty-free cigarette export data presented  potential compliance issues with reporting requirements, we reviewed  such data from AES and compared select data elements to reporting  requirements as stated in the Foreign Trade Regulations.  We also  reviewed summaries of events that CBP provided relating to a specific  penalty issued by the port of Laredo to a duty-free store operator for  failure to comply with AES reporting requirements. We examined a  document Census provided to us that was submitted to that agency and  CBP from the operator’s lawyers as well as the interim document  provided to that operator by CBP and Census. We also analyzed a subset  of our data concurrently with agency officials to evaluate the compliance  of the specific transaction records we received from Census with a  requirement in the Foreign Trade Regulations. Additionally, we reviewed  documents from the Commercial Customs Operations Advisory  Committee to contextualize one of the largest duty-free store operator’s  use of its postdeparture filing privilege.

We conducted this performance audit from November 2016 to October  2017 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.

Appendix II: Assessment of Duty-Free Cigarette Export Data Reliability

We analyzed U.S. Census Bureau (Census) transaction-level data from  the Automated Export System (AES) on sales of duty-free cigarettes  purchased at stores located on the U.S. southwest border from 2010  through 2015. Census collects electronic export information in AES to  report trade statistics, including the export of duty-free cigarettes. Stores  that are principal parties to a sale of duty-free cigarettes for export  generally self-report the transaction through AES. Some duty-free  operators integrate point-of-sales systems to AES for automatic entry,  and some enter the data manually or into software programs that are  approved by Census, according to U.S. Customs and Border Protection  (CBP) officials. Self-reported data captured in AES include transaction- related variables such as date of export, port of export, value, quantity,  weight, method of transportation, and ultimate consignee. Census then  uses the AES data to compile and publish export trade statistics.

CBP and Census share responsibility for monitoring compliance with  trade law, including the data reporting requirements that duty-free stores  must meet. According to CBP officials, CBP officers regularly review  duty-free store operators’ inventory control and recordkeeping systems  during unannounced spot checks and compliance assessments.  However, according to these officials, CBP’s compliance reviews of  inventory control systems do not generally include an examination of how  store operators report data in AES. AES is built to include automated  electronic checks of stores’ AES submissions as the data are entered;  these data-entry validation checks produce alerts when required  information is invalid or missing. Census also sometimes sends staff to  meet with companies that have a high rate of submission errors, such as  reporting shipments late.

If they identify problems with the accuracy of the information that store  operators are filing in AES, CBP and Census can take appropriate steps  to enforce compliance with the law. CBP is responsible for the  enforcement of the Foreign Trade Regulations. When data are  incorrectly entered in AES, CBP can take enforcement action, including  issuing penalties or seizing merchandise, according to CBP officials.  Census can also respond to noncompliant reporting of electronic export  information by operators by revoking special privileges granted to some,  such as permission to file export information after a shipment has been  exported, among other actions. In compiling and analyzing AES data,  Census makes corrections to some data that appear erroneous, but CBP  officials said that Census does not flag or report the data corrections it  makes to CBP. Census officials stated that, while they reach out to some  filers to suggest corrective action, the scale of the trade data program and  the number of transactions processed every month precludes  comprehensive outreach.

Duty-Free Cigarette Data Collected through AES Are Not Reliable for Analysis of Value and Quantity of Exports or Associated Trends

Evaluating Unprocessed, Transaction-Level AES Data on Duty-Free Cigarettes

Our testing found that the unprocessed transaction-level AES data on  duty-free cigarettes for 2010 through 2015 are not reliable for use in  describing the value and quantity of duty-free cigarettes, and associated  trends, exported from the southwest border. For that time period, we  received data on 18,504 transactions of duty-free cigarettes that had a  reported value of $2,500 or above, in keeping with AES reporting  requirements. To examine the data on value and quantity, we evaluated  the reasonableness of the ratio of these variables, the unit price (value  divided by quantity), and the consistency and stability of reported prices.  We found that many of these transactions’ reported unit prices are far  below reasonable price levels. For example, 2.3 percent of transactions in  these unprocessed data are associated with a unit price of under $4.42  per 1,000 cigarette sticks—the cost of tobacco on commodity markets as  of calendar year 2015, which excludes necessary costs of cigarettes such  as paper costs and manufacturing costs. However, these transactions  with extremely low unit prices account for more than 98 percent of the  quantity of trade in duty-free cigarettes as reported in the AES data we  obtained. Moreover, 39 percent of the reported transactions (accounting  for more than 99.6 percent of the total reported quantity sold) were  associated with unit prices lower than what we conservatively estimate to  be the price at which duty-free stores could procure cigarettes from  manufacturers, as discussed in the section below. We also found high  levels of reported price variation in the data, with reported median unit  sales prices frequently doubling or halving from year to year, even within  the same port location.

Evaluating Census’s Data- Processing Methodology and Assumptions

Census is responsible for collecting, compiling, and publishing AES trade  data for duty-free cigarettes, and Census officials said that they clean and  correct (process) these data by changing value entries to equal a “price  adjustment factor” when the unit price of transactions falls outside of an  expected range, as explained below. For cigarette exports as of February  2017, including those transactions exempt from taxes and duties, these  officials said that this range includes a minimum of $11 per 1,000  cigarette sticks, a price adjustment factor of $40 per 1,000 sticks, and a  maximum of $75 per 1,000 sticks. According to these officials, Census  sets its price range and adjustment factor by examining the data and  identifying outlier levels based on judgment. Census officials stated that  they updated this expected price range in February 2017. Census officials  stated that price adjustment factors are not updated on a fixed schedule  and do not automatically adjust for inflation. Instead, Census may choose  to update factors when it believes there have been significant changes in  an industry’s trade patterns. According to these officials, prior to February  2017, the price range for cigarettes was last updated in 2007. From 2007  through January 2017, the price adjustment factor for cigarettes was  $11.46—about one-fourth of its current value—with a minimum of $8.87  and a maximum of $27.39.

Census’s current price range for cigarettes is not appropriate for cleaning  data to analyze trends in duty-free cigarette exports because it may  significantly underestimate a reasonable expected price range for  cigarettes. Approximately 39 percent of the observations in the  unprocessed, duty-free cigarette data are associated with sales prices  below Census’s minimum price or above Census’s maximum price. We  estimated minimum and maximum expected prices for cigarettes that are  substantially greater than Census’s current price adjustment factor range  for cigarettes.

To estimate a minimum expected price for cigarettes, we examined  commodity prices, production costs, and revenue data from a large,  publicly traded cigarette manufacturer. We found that the  manufacturing cost of cigarettes exceeded Census’s estimated  minimum sales price by 30 percent, $14.26 per 1,000 cigarette sticks  instead of $11. Thus, even if the manufacturer sold its cigarettes  directly to a duty-free store, and neither the manufacturer nor the  duty-free store made a profit, we would still expect a price greater  than Census’s lower bound.

This expected minimum retail price increases significantly if we  account for cigarette manufacturers’ revenue. Using revenue data  from the public accounting statements of the same manufacturer, and  again conservatively assuming direct sales to a duty-free store that  itself sells for no profit, we would expect to see a price of $43.65 per  1,000 cigarette sticks, which is nearly 300 percent greater than  Census’s lower bound of $11 per 1,000 cigarette sticks and about 9  percent larger than Census’s current price adjustment factor of $40  per 1,000 sticks.

To estimate a maximum expected price for cigarettes, we examined  the price of a premium cigarette brand listed for sale on a duty-free  store’s website. We found that this price was 163 percent higher than  the upper bound in Census’s price range, $197.50 per 1,000 cigarette  sticks instead of $75 per 1,000 sticks.

For any observed prices in trade data outside of this expected range for a  given tariff code, Census officials said that they attempt to correct these  observations by adjusting the reported quantity such that the reported  price is equal to the price adjustment factor—$40 per 1,000 cigarette  sticks. For example, if a reported sale is $80 per 1,000 cigarette sticks,  Census will adjust the reported quantity to 2,000 sticks while leaving the  reported value unchanged, so the reported price (value divided by  quantity) becomes $40 for each unit of 1,000 sticks. Census officials  stated that this data cleaning process is sufficient for their use in  producing aggregated trade statistics because of the volume of  transactions they must review and the ease with which Census analysts  can apply this method to clean trade data.

Census’s process of correcting missing or outlying data (unreliable data)  with its price adjustment factor is not appropriate for our use because it  would significantly alter the relationships among subgroups within our  data, distorting trends that we otherwise would intend to analyze. For  example, in a hypothetical dataset where the average sales price is $40  per 1,000 cigarette sticks across exports from the United States,  Census’s replacement of missing and outlying data using a price  adjustment factor of $40 would not change this overall average. But if one  state in the data has an average sales price lower than the national  average, reflecting lower costs of doing business, any missing or outlying  data replaced with the same price adjustment factor as other higher  costing states would increase the state’s reported average sales price.  The distinction between high-price states and low-price states would thus  become less clear.

Moreover, we cannot determine the appropriateness of Census’s decision  to preserve reported value and adjust reported quantity when processing  data to manage the relationship between value, quantity, and price. This  is because we cannot determine whether the unprocessed value or the  unprocessed quantity data are reliable. Applying our minimum expected  price for cigarettes, discussed above, excludes many transactions in the  unprocessed data, indicating problems with value, quantity, or both.  Census officials stated that they believe the value data are more reliable  than the quantity data and so change the reported quantity data when  processing the data, though they also stated that this is a general  assumption without specific insight as to whether or why this method may  be valid for cigarettes. While CBP officials stated that high-level postaudit  checks can be used to ensure that a store’s AES system is working  properly, they said that these checks are rare, and the inventory control  system compliance review does not otherwise provide assurance that  data self-reported into AES are reliable. CBP officials stated that they  were not confident about which transaction data in AES were more  reliable: value or quantity. Because neither agency’s control process  provides strong assurance that either the value or the quantity data are  reliable for our use, we cannot appropriately use value, quantity, or price  as a benchmark to correct the other variables.

Evaluating Alternative Data-Processing Techniques

Alternative methods for determining appropriate replacement values for  outlying data, referred to as imputation, would not make the duty-free  cigarette data reliable for our intended use. For example, stochastic  regression imputation replaces a missing or excluded variable value  within an observation by drawing randomly from within the error  distribution of a best-fit model. Correctly specifying such a model allows  data processing to occur while preserving the dataset’s overall average  values, correlations, and variation. However, identifying the observations  that require correction remains a challenge. As discussed above, we can  estimate the approximate manufacturer’s sales price for cigarettes. In the  absence of additional proprietary data, we are unable to determine a price  range that accounts for retail store costs and profit. Without this  information, and given that the duty-free cigarette data include significant  and questionable variation of reported prices even within our estimated  price band, it is not possible to identify which observations require  correction or deletion with appropriate levels of confidence. Lacking a  clear basis for finding either the value data or quantity data reliable, we  also cannot appropriately determine how to manage the relationship  between value and quantity if we were to impute replacement price levels  for these observations.

Appendix III: Comments from the Department of Homeland Security

Appendix IV: GAO Contact and Staff Acknowledgments

In addition to the contact named above, Emil Friberg (Assistant Director),  Farhanaz Kermalli (Analyst-in-Charge), Giff Howland, David Dayton, Neil  Doherty, Andrew Kurtzman, and Grace Lui made key contributions to this  report. Pedro Almoguera, Ming Chen, Jill Lacey, and Mary Moutsos  provided technical assistance.

Unlike airport duty-free shops, U.S. duty-free stores on the border with Mexico can sell you an unlimited quantity of tax-free cigarettes. Sometimes criminals buy thousands of dollars' worth of these cigarettes to sell illegally (as shown below), which can generate revenue for organized crime.

This report examines the illicit trade in cigarettes on the southwest border and some challenges U.S. Customs and Border Protection and other agencies face in countering it. We recommended that CBP take steps to strengthen compliance with export reporting requirements for duty-free cigarette sales.