New Twists in the Rum Cover Over Saga

FILED APRIL 19, 2011

Dear Client:

Fights, politics, whisky, and money. All the elements of a great story, and the long-running feud between Puerto Rico and the US Virgin Islands over the rum cover over (RCO) tax breaks has them all in spades, and that story has been well-documented here and elsewhere. But it has emerged that the rum cover over story has an interesting twist, which may have repercussions not just on the rum market, but a ripple effect throughout all of beverage alcohol. More on that later.

BACKGROUND. First, to refresh your memory, let's review the situation. The RCO started in 1917 as a way to level the playing field between rum produced in the fledgling US territories and spirits produced in the states, and to return a good portion of the excise tax generated by that rum to the U.S. territories for economic development. Of the $13.50 paid in federal excise taxes per gallon proof of rum brought into the US, $13.25 is sent back to the governments of the territories, which for the most part historically was Puerto Rico, the home of Bacardi and former home of Captain Morgan, which received about 80% of the RCO revenue while USVI got 20%. Puerto Rico used less than 10% of that returned tax to promote Puerto Rican rum. The RCO program has been good for the rum category, which has grown from about a 5% market share of spirits in the US forty years ago to over 20% today. Of course, part of that growth is through excellent marketing by Bacardi and others, but at least some of that growth could be attributed to the tax break Puerto Rican rum has received.

THE GAME CHANGER. A few years ago Diageo met with US Virgin Islands governor John P. de Jongh Jr. and struck a deal. Critics have claimed Sen. Charlie Rangel was involved in the deal, but Diageo issued a statement in September 2010 denying that: "The 30-year public-private initiative between Diageo and the government of the US Virgin Islands is a local agreement. No member of the United States Congress played a role in negotiating or approving it."

In exchange for around $2.7 billion in tax incentives over 30 years, Diageo would move Captain Morgan production from Puerto Rico to St. Croix, USVI, at a new distillery funded by USVI. The 30-year deal is also renewable, and at the end of 30 years Diageo gets the title to the distillery. That deal sparked a public relations and political war between Puerto Rico and USVI (and by extension Bacardi and Diageo), as Puerto Rico stands to lose jobs and about $130 million in RCO revenue. At the time, Bacardi said in a statement to WSD, "This issue is about one point - the appropriate use of approximately 2.7 billion dollars in taxpayer money. This isn't about where Diageo receives a free distillery, but about the proper use of federal tax dollars. Diageo has some explaining to do to the U.S. Congress and American people." Diageo's evp Guy Smith told WSD at the time, "Through a quirk in federal law, Bacardi can protect their huge government subsidies by driving Captain Morgan rum production anywhere rather than the U.S. Virgin Islands. Look, if they are successful in driving us out of the US, Puerto Rico will receive more money for doing nothing...This is a very important economic program for the USVI. It is the poorest of any territory or state, and they need this deal."

Even the New York Times weighed in, calling the Diageo-USVI deal a "tax hangover" and pointing out that the deal is "so rich they are double the cost of actually producing the rum" so that even if they gave Captain Morgan away for one penny over the excise tax, they'd make a profit. Diageo has said that is not the case.

Soon Fortune Brands cut a similar deal with USVI for their Cruzan Rum worth about $700 million, and Bacardi cut a separate peace with Puerto Rico worth about $4 billion (about $130 million a year in perpetuity). Needless to say, the distillers who have the bulk of their operations stateside were not amused, not to mention Puerto Rico. A bill was introduced in last year's Congress to cap the amount of RCO money that the territories can use for corporate incentives at 10%. That bill died in the House Ways and Means Committee, which was chaired by Charlie Rangel.

This year, another bill is being prepared which would cap the incentives at 20% of RCO money. The new bill would also direct the Treasury Department to allocate cover-over revenue to each territory in proportion to that territory's production. And finally, it would close a potential loophole in the law by prohibiting cover-over grants to a territory in connection with the production of bulk rum that is later re-distilled into cane neutral spirits (CNS) to make whiskey blends, vodka, gin, brandy and other non-rum spirits. CNS could even be used as the alcohol in ready-to-drink cocktails.

THE TWIST. While the rich RCO deals have given indie stateside distillers some anxiety -- as presumably it could give territory rum producers a significant price advantage and/or more money to put into marketing versus competing spirits categories like whiskey or vodka -- there's another issue which has crept up that gives them full-on heartburn.

Last year Fortune Brands submitted a label request change to the TTB for two blended whiskey labels called PM De Luxe, using 80% cane neutral spirits and 20% blended whiskey, and Beam's Eight Star, using 75% cane neutral spirits and 25% whiskey. Cane neutral spirits are made from molasses or sugar, like rum, instead of grain like most whiskeys. The TTB approved the labels. When pressed on whether cane neutral spirits brought into the US from Puerto Rico or the USVI receive the RCO tax benefit, the TTB essentially said, no, cane neutral spirits are not covered. However - and there's the kicker - the TTB did say that rum brought into the US from the territories would receive the RCO, even if that rum is later redistilled into cane neutral spirits to be blended into other spirits.

In October Fortune told the New York Times it wanted to preserve its "flexibility" and had no plans to use cane spirits in other products. When contacted by WSD, a Fortune spokesman told us: "We are not using cane neutral spirit in any of our products and we have no current plans to do so." Although Fortune applied for the above-mentioned labels, they were "not pursued."

The TTB approved a label for Bacardi just last week for a vodka called Nadja made from 100% cane neutral spirits. A request for comment from Bacardi was not returned by press time.

Diageo has not applied for any labels that include cane neutral spirits. Diageo told WSD: "The Diageo USVI distillery is in the business of making rum. We do not currently use cane neutral spirits from the USVI in our products, nor do we plan to do so in the future."

While it hasn't happened yet, it becomes conceivable that those distillers who enjoy capacity at their rum distilleries in the territories can make any type of spirits they want by redistilling it into cane neutral spirits in the US, thereby getting a significant tax advantage, which again could translate into a price and/or marketing advantage. In fact, if cane neutral spirits were used in every type of spirit where it could be used (prepared RTDs, cordials, liqueurs, gins, vodkas, and blended whiskeys), it could cost the Treasury as much as $1.8 billion a year (from the current $500 million), with about half of that going back to the producing distillers based on their various deals with the territories. Of course, we're a long way from that happening. And the fact that the distillers - while they have a few label approvals to use cane neutral spirits - have yet to actually market one to our knowledge, may indicate that they do not wish to go down this road. Why? Because as the saying goes, pigs get fat and hogs get slaughtered. If the Treasury starts bleeding money into the billions to the US territories, somebody in Congress could wake up and decide to the kill the entire RCO program.

Still, WSD has learned that several stateside distilleries are looking into building or contracting production in the USVI. And who could blame them? The RCO is a sweet deal.


SPI GROUP has named Jim Schleifer its svp of North America. He will report to Val Mendeleev, ceo of the SPI Group. His appointment follows the exit of Andrey Skurikhin from SPI at the end of 2010 to pursue other interests. Jim has held various sales and marketing positions at Seagram Americas, The Absolut Spirits Co and Jose Cuervo International. He most recently worked with Kanon USA to launch its new brand, Kanon Organic Vodka.

MALIBU RUM is launching the latest flavor, Tropical Sea Breeze, for its line of premixed cocktails. Like the other Malibu Cocktails products, it will be packaged in environmentally friendly 1.75L pouches. It retails for a suggested price of $19.99/1.75L.

Until tomorrow, Megan

"She got her looks from her father. He's a plastic surgeon."
Groucho Marx

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