In October 2019, the California Department of Tax and Fee Administration (CDTFA) issued a blatantly discriminatory Special Notice changing how the CDTFA will apply the excise tax for Other Tobacco Products (OTP) to the wholesaler’s cost basis when an out-of-state California distributor sells tobacco products to wholesalers, retailers, or consumers located in California. When a shipment is made by an out-of-state distributor to an in-state customer (retailer or adult consumer), the tax base will be the “wholesale cost” of the in-state purchaser and not the wholesale cost of the distributor. In-state California distributors will not be impacted as they will continue to pay the tax based on their cost. While CDTFA has indicated that the Special Notice is a clarification of its interpretation of the “wholesale cost” tax base, it is inconsistent with CDTFA’s long-standing application of the wholesale cost tax base. Historically, CDTFA has required distributors to remit the tax based on their “wholesale cost” regardless of whether the distributor is located inside the State. We believe the Special Notice, which re-interprets California’s Regulation 4076 (Wholesale Cost of Tobacco Products), is subject to challenge on various grounds, some of which we address below.
First, CDTFA’s issuance of the Special Notice is a clear violation of California’s Administrative Procedure Act which was designed to “provide the public with a meaningful opportunity to participate in the adoption of state regulations and to ensure that regulations are clear, necessary and legally valid.” The Special Notice is nothing short of a disguised regulation. In fact, in October 2018, CDTFA issued draft regulations (Proposed Amendment to Regulation 4011) , which have yet to be adopted. The Draft Regulations indicate that its purported “clarification” of its position would only be applied prospectively. By issuing the Special Notice, California disregarded its statutory obligations to follow the process set forth in the Administrative Procedure Act.
Second, CDTFA’s interpretation is simply inconsistent with the plain language of the statute which does not distinguish between in-state and out-of-state sellers.
Finally, CDTFA’s position set forth in the Special Notice discriminates against out-of-state distributors (including online retailers and other remote sellers) and can be challenged under the federal Dormant Commerce Clause legal doctrine, which holds that states cannot discriminate against interstate commerce nor can they unduly burden interstate commerce. The Commerce Clause violations established by the Special Notice are blatant on its face because it treats identical taxpayers differently based solely on whether they are located in California.
Tobacco products distributors are responsible for remitting the tobacco products excise tax to the CDTFA if they are making distributions in California. Distributors purchase tobacco product before any California excise tax is due and then pay the tax when they sell or distribute the products. The excise tax is calculated as the “wholesale cost” of the tobacco products multiplied by the tobacco products tax rate (currently set at 59.27% through July 2020).
For distributors located in California, the “wholesale cost” per the Special Notice is the cost of tobacco products to the distributor prior to any discounts or trade allowances (which is the cost set forth in Cal. Rev. and Tax Code Section 30017). However, for distributors located outside California, the CDTFA now is stating that the “wholesale cost” on which the distributor’s excise tax is based is the California customer’s wholesale cost (e.g. in the case of an online retailer located outside of California, the retail cost to the adult consumer) and not the cost to the distributor. In practice, this means that the base of the excise tax likely will be significantly higher for non-California distributors (including online retailers and other remote sellers) than for distributors operating within the state.
For example, imagine two distributors, one based in California, the other out of state, who purchase the same tobacco product from a manufacturer for $1.00 per unit. When both re-sell those products in California, either to a retailer (for $2.00 per unit) or by delivery to an individual consumer ($4.00 per unit), the different tax bases lead to significant differences in amount of excise tax owed.
In the in-state scenario, the California distributor pays excise tax based on the wholesale cost paid to the manufacturer (here, tax amounts to $0.59), regardless of whether the packs are sold to a retailer or an adult consumer. The out-of-state distributor, however, pays significantly more excise tax under either scenario (tax of $1.19 or $2.37 per unit – a tax increase here of more than 200% to 400%), as the wholesale cost is calculated against its first in-state sale rather than purchase price.
If you are interested in learning more about how the Special Notice impacts your Company or joining a group of affected parties to challenge the Special Notice, please contact:
Agustin E. Rodriguez
Troutman Sanders LLP
Direct: 804.697.1381 Mobile: 804.629.0669
All inquiries will be treated in confidence.