Management's Discussion and Analysis of Financial Condition and Results of Operations

(Continued)

Discussion and Analysis Operating Results by Business Segment Tobacco Business Environment

Taxes, Legislation, Regulation and Other Matters Regarding Tobacco and Smoking

The tobacco industry, both in the United States and abroad, faces a number of challenges that may continue to adversely affect the business, volume, results of operations, cash flows and financial position of PM USA, PMI and ALG. These challenges, which are discussed below, include:

• a compensatory and punitive damages judgment totaling approximately $10.1 billion against PM USA in the Price Lights/Ultra Lights class action, and punitive damages verdicts against PM USA in other smoking and health cases discussed in Note 18. Contingencies ("Note 18");
• the civil lawsuit filed by the United States federal government seeking disgorgement of approximately $289 billion from various cigarette manufacturers, including PM USA, and others discussed in Note 18;
• pending and threatened litigation and bonding requirements as discussed in Note 18;
• price increases in the United States related to the settlement of certain tobacco litigation, and the effect of any resulting cost advantage of manufacturers not subject to these settlements;
• actual and proposed excise tax increases as well as changes in tax structure in foreign markets;
• the sale of counterfeit cigarettes by third parties;
• the sale of cigarettes by third parties over the Internet and by other means designed to avoid the collection of applicable taxes;
• price gaps and changes in price gaps between premium and lowest price brands;
• diversion into the United States market of products intended for sale outside the United States;
• the outcome of proceedings and investigations involving contraband shipments of cigarettes;
• governmental investigations;
• actual and proposed requirements regarding the use and disclosure of cigarette ingredients and other proprietary information;
• actual and proposed restrictions on imports in certain jurisdictions outside the United States;
• actual and proposed restrictions affecting tobacco manufacturing, marketing, advertising and sales inside and outside the United States;
• governmental and private bans and restrictions on smoking;
• the diminishing prevalence of smoking and increased efforts by tobacco control advocates to further restrict smoking;
• governmental regulations setting fire safety standards for cigarettes; and
• other actual and proposed tobacco legislation both inside and outside the United States.

Excise Taxes: Cigarettes are subject to substantial excise taxes in the United States and to substantial taxation abroad. Significant increases in cigarette-related taxes have been proposed or enacted and are likely to continue to be proposed or enacted within the United States, the European Union (the “EU”) and in other foreign jurisdictions.

These tax increases are expected to continue to have an adverse impact on sales of cigarettes by PM USA and PMI, due to lower consumption levels and to a shift in sales from the premium to the non-premium or discount segments or to sales outside of legitimate channels.

Tar and Nicotine Test Methods and Brand Descriptors: Authorities in several jurisdictions have questioned the utility of standardized test methods to measure average tar and nicotine yields of cigarettes. In 2001, the National Cancer Institute issued its Monograph 13 stating that there was no meaningful evidence of a difference in smoke exposure or risk to smokers between cigarettes with different machine-measured tar and nicotine yields. In 2002, PM USA petitioned the FTC to promulgate new rules governing the disclosure of average tar and nicotine yields of cigarette brands. In response to evolving scientific evidence about machine-measured low-yield cigarettes, which represents a fundamental departure from the scientific and public health community’s prior thinking about the health effects of low-yield cigarettes, public health officials in other countries have stated that the use of terms such as “Lights” to describe low-yield cigarettes is misleading. The EU Commission has been directed to establish a committee to address, among other things, alternative methods for measuring tar, nicotine and carbon monoxide yields. Public health officials in the EU and Brazil have prohibited the use of brand descriptors such as “Lights” and “Ultra Lights,” and public health authorities in other jurisdictions have called for such prohibitions. PMI has communicated to national governments, including the EU, as well as the World Health Organization (“WHO”), its views on the need for regulation of how tar and nicotine yields in cigarettes are measured and how this information is communicated to consumers. See Note 18, which describes pending litigation concerning the use of brand descriptors.

Food and Drug Administration (“FDA”) Regulations: PM USA has stated that while it opposes FDA regulation over cigarettes as “drugs” or “medical devices” under the Food, Drug and Cosmetic Act (“FDCA”), it would support new legislation that would provide for meaningful and effective regulation by the FDA of tobacco products. Currently, bills are pending in Congress that, if enacted, would give the FDA authority to regulate tobacco products; PM USA has expressed support for one of the bills. The pending legislation could result in substantial federal regulation of the design, performance, manufacture and marketing of cigarettes. In addition, some of the proposed legislation would impose fees to pay for the cost of regulation and other matters. The ultimate outcome of any Congressional action regarding the pending bills cannot be predicted.

Tobacco Quota Buy-Out: Bills are pending in Congress which, if enacted, would result in a “buy-out” of U.S. tobacco quotas. These bills would fund a quota buy-out by imposing new fees or assessments on all manufacturers of tobacco products sold in the United States. PM USA has voiced support for certain buy-out proposals if they are part of legislation granting the FDA authority to regulate tobacco products.

Ingredient Disclosure Laws: Jurisdictions inside and outside the United States have enacted or proposed legislation or regulations that would require cigarette manufacturers to disclose the ingredients used in the manufacture of cigarettes and, in certain cases, to provide toxicological information. In some jurisdictions, proposals have also been discussed that would permit governments to prohibit the use of certain ingredients. Under an EU tobacco product directive, tobacco companies are now required to disclose ingredients and toxicological information to each Member State. In implementing the EU tobacco product directive, the Netherlands has issued a decree that would require tobacco companies to disclose the ingredients used in each brand of cigarettes, including quantities used. PMI and others have challenged this decree in the Dutch District Court of The Hague on the grounds of a lack of appropriate protection for proprietary information.