Let Them Tax Cake?

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For obvious reasons, investors globally have been spending a lot of time thinking about business taxes lately. For that is what tariffs are: a tax. And conventional wisdom says higher taxes are bad for stocks because they eat into profits—simple math. But from markets’ standpoint, it isn’t quite that simple. The question is more, how do new taxes shape expectations, and what do companies then do to beat those expectations? One creative response is playing around with a product’s composition to qualify it for the lowest tariff rates or some of the 1,000-plus exemptions included in Liberation Day tariffs. While this is only just getting started, UK grocers are showing the way, with … sandwiches.

Like most tax systems, the UK’s value-added tax (VAT) is complex, with various reductions and exemptions. This includes VAT on food. Nutritious food is VAT-free.^[i] But confections are standard-rated, with the full 20% VAT.^[ii] So this summer, grocers seem to have found a creative workaround: ye olde sandwich.

Sandwiches, as one typically thinks of them, are nutritious and delicious food. Meat, cheese, produce and condiments between two slices of bread. Or peanut butter and jam between two slices of bread. Protein, fiber, carbohydrates, maybe some dairy, probably some sugar, hopefully some good vitamins and a healthy dose of energy to get through your afternoon. Hence, sandwiches are generally VAT-free.

Cake is not VAT-free. It is a confection. So what does a grocery store do if it wants to capture more of the cake market without raising prices to cover VAT, which is typically embedded in the price? Evidently, the solution may be turning a cake into a sandwich.

One grocery store went viral this summer for its strawberry and cream sandwich, which consists of ruby-red British strawberries and “whipped cream cheese” inside two slices of “sweetened bread.”^[iii] Was it tasty? Was it a sandwich? Was it taxed?

These questions have preoccupied UK financial writers for the past several weeks, with most attention on the latter two. There was an entire cottage industry devoted to determining the tax status of this one sandwich. The grocer kept mum, which may be the most brilliant PR move of the summer, ensuring it stayed in headlines with the debate reaching is a taco a sandwich levels of infamy. It went into Marie Antoinette territory, with a dissection of the brioche-like bread and whether its lack of eggs kept it safely out of the cake column.^[iv] Was the whipped cream cheese more “cheese” or “cream?” How did the sodium, sugar, fat and calorie content square with concoctions HMRC would normally consider food for tax purposes? The general consensus was that it was most likely a sandwich, but if it ever went to a tax tribunal, it might be one of the most complicated and entertaining cases of all time.

Which may be why a competing grocery store just threw its hat in the ring with its new “Birthday Cake Sandwich.” Here, too, we have brioche-style white bread, with a filling of “strawberry jam, soft cheese, vanilla frosting and sprinkles.”^[v] It is being sold as a sandwich. It is an option for sandwich meal deals. Early reviews say it is not tasty. But if it is also not taxed, we guess we must tip our hat. It is dessert, it is a sandwich, it has perhaps gamed the system and won.

UK grocers aren’t exactly breaking new ground here. Japan has been at a similar game for many years, with drinks companies inventing an entire category of alcoholic beverages to skirt the high tax on drinks with high malt content—basically a beer tax. Enter “quasi beer,” which are low-malt sparkling alcoholic drinks. They are brewed like beer, with a slightly different flavor profile due to the lower malt content. High taxes initially started at a malt content of 67% of fermentable ingredients. But as the quasi-beer market boomed and tax revenue declined, the government lowered the limit, and quasi-beermakers adapted. If you have ever wondered why Zima remains on the market and popular in Japan, this is why. Tax beer, and you create a market for non-beer or quasi-beer or what have you.

Companies have long used similar strategies to avoid tariffs. Readers of a certain age may remember the infamous Subaru BRAT, a quirky compact pickup sold in the US in the late 1970s and early 1980s. The US has long charged a very annoying tax on imported light-duty trucks to retaliate for a European tariff on American chicken, so Subaru plonked two rear-facing passenger seats in the flatbed and boom! The truck became a passenger vehicle, avoiding the “chicken tax” and slashing the tariff rate to 2.5%.^[vi]

Shoemakers have played a similar game, inserting layers of fabric to qualify as a fabric-soled shoe—thus avoiding higher tariffs on rubber-soled shoes—or felt to morph athletic shoes into “slippers” for tariff purposes.

We have a very, very strong hunch businesses nationwide are currently scrutinizing the Liberation Day exemption list for such opportunities. The more complex a tax system is, the more gameable it is—much as, even when the US charged an eye-watering 35% corporate tax rate before 2017’s cuts, most businesses paid far less than that after taking advantage of all the credits and deductions.

It may not be the best use of time, energy and brainpower, but when have businesses ever existed in “best”? Ideal doesn’t exist. What matters for markets is that as businesses deploy their creativity and find ways to minimize their tariff bill, levies’ costs should remain much milder than the worst-case scenario estimates markets priced in early April. You may or may not like the current landscape, but for markets, our feelings are beside the point. As long as corporate earnings shape up better than expected over the next 3 – 30 months, that is generally good enough. And if clever tariff avoidance plays into that, seems to us like the kind of thing to celebrate with a bizarre dessert sandwich.