Cigarettes Set To Get Costlier: Revenue Would Say 'Thank You For Smoking'

The government has announced a significant restructuring of how cigarettes and other tobacco products are taxed, marking one of the most substantial shifts in tobacco taxation since the introduction of the goods and services tax in 2017. At the heart of this change is a steep increase in the GST and central excise duty on tobacco products. But that is not all. The way these products are valued for tax purposes is also changing fundamentally, moving to a system based on the 'Maximum Retail Price' printed on the pack.

The compensation cess, an additional levy that has been charged on tobacco products since the GST's inception, is being withdrawn entirely. While this might sound like relief, the steep increase in the GST rate from 28% to 40%, along with a significant hike in central excise duty and introduction of new valuation methodology, will more than offset this withdrawal.

Perhaps the most significant change is the shift towards MRP-based valuation. Under the new system, the taxable value of cigarettes will be calculated with reference to the retail price printed on the package, rather than the actual transaction value between manufacturers and distributors. In simple terms, the taxable value will be computed by working backwards from the MRP to arrive at a pre-tax value, and 40% GST will be applied to this figure. This approach seeks uniform taxation, curtails tax evasion across the supply chain and simplifies tax administration.

However, this new valuation method could face challenges in courts. The argument is centred on a fundamental principle that the taxable base for levy of GST is the 'transaction value', — the price paid or payable for a supply, which must have a direct nexus with the taxable event and not the eventual retail sale to consumers. This position finds strong support in the Supreme Court’s rulings, which hold that a tax base cannot be fixed by reference to the MRP, which is neither charged nor chargeable in the taxable transaction.

For cigarette manufacturers and importers, the changes are material. They will now pay the 40% GST on the MRP-based value, continue paying enhanced central excise duties, and remain subject to the rule requiring them to pay at least 1% of their tax liability in cash rather than using input tax credits entirely.

However, owing to the relaxation in the rules, the distributors, wholesalers or other stakeholders down the line will be exempt from the 1% cash payment requirement, though they may still face situations where credits pile up without easy ways to utilise them in the same line of business.

Retailers, particularly those operating under the composition scheme for small businesses, will find the GST already embedded in their purchase price. They won't charge separate GST to consumers, since the MRP-based system ensures consistent pricing across all retail outlets.

One issue that tobacco companies are scrambling to address is what happens to the compensation cess credits they have accumulated. Until January 2026, businesses continue paying this cess on their inputs and can claim credits for it. But once the cess is withdrawn on Feb. 1, there will be no output cess liability against which these credits can be used. This creates 'stranded credits', taxes paid to the government, credits of which cannot be recovered or utilised.

The automobile and coal industries faced similar situations (post GST 2.0 in September 2025) when cess rates on their products were brought down to 'Nil', leaving such industries with significant unusable balances on their books with no explicit mechanism for adjustment or refund. A long battle in this regard has already been initiated by the Automobile Dealers Association before the Supreme Court. The coal and tobacco sectors are expected to join them in this challenge, as the dispute has significant revenue implications and raises issues of statutory interpretation.

Across the past half‑century, steep excise taxes on cigarettes and other tobacco products have been the cornerstone of global tobacco control by raising prices, curbing affordability and reducing consumption. Notable successes include Australia and the United Kingdom, where sustained excise hikes helped drive smoking prevalence to record lows; South Africa’s 1990s–2000s reforms, which sharply cut the per‑capita consumption; the Philippines' 2012 'Sin Tax', which boosted revenues while accelerating declines; and Canada and several states in the USA, where high taxes materially reduced youth initiation.

The Indian government's move aligns with its long-standing policy of discouraging tobacco consumption through taxation. With India bearing among the highest tobacco-related disease burdens globally, successive governments have used fiscal policy as a public health tool. The shift to MRP-based valuation also addresses a persistent challenge in tobacco taxation, ensuring that the tax collected reflects the actual consumer price rather than potentially understated transaction values within the supply chain. Whether this delivers higher revenue while reducing tobacco consumption remains to be seen. What's certain is that the February 2026 changes mark a significant milestone in India's approach to taxing one of its most controversial product categories.

Accordingly, the consumers must brace for a price hike; industry will need to gear up to implement this new tax and valuation mechanism within a month and the government should be prepared to defend potential challenges to the MRP-based valuation mechanism, including representations around refunding or permitting cross-utilisation of stranded Compensation Cess credits.