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Sarah Bradford highlights potential benefits and pitfalls of salary sacrifice arrangements.

Introduction

Although as a general rule an employee is taxed on non-cash remuneration such as benefits in kind, the tax legislation contains a number of exemptions that make it possible to provide certain benefits free of tax and National Insurance contributions. However, a benefit is only worthwhile if the employee actually wants to receive it and not all employees will value the same non-cash benefits.

The challenge is to take advantage of the tax exemptions on offer, whilst offering a degree of individual choice without increasing the overall cost to the employee.

Luckily, salary sacrifice arrangements offer a solution to this dilemma.

Nature of Salary Sacrifice

Under a salary sacrifice arrangement an employee gives up some of his or her cash salary in exchange for a non-cash benefit. Where the benefit in kind is exempt from tax and National Insurance, the employee is better off financially than if he or she had continued to take the salary and then paid for the `benefit’ from his or her net pay. The employer also saves the National Insurance that would have been payable on the cash salary foregone.

Childcare vouchers, which are exempt up to a value of £55 per week, are typically provided by means of such an arrangement. By swapping £2,860 of cash salary for childcare vouchers of £55 per week, a basic rate taxpayer saves tax of £572 and (at the main rate of 11%), National Insurance of £314.60. A higher rate taxpayer saves tax of £1,144 and National Insurance (at the additional rate of 1%) of £28.60. The employer also saves National Insurance of £366.08 (£2,860 @ 12.8%).

There are still benefits to be had if the employee swaps salary for a non-exempt benefit in kind. This is because most benefits in kind are subject to Class 1A National Insurance contributions rather than Class 1. As the Class 1A charge is an employer-only charge, moving the liability from Class 1 to Class 1A means the employee saves National Insurance. If the employee pays National Insurance at the main rate of 11%, this can be worthwhile. However, in this situation there are no savings available to the employer.

Avoiding the Pitfalls

The tax savings will only materialise if the taxman regards the arrangement as `effective’. This means that the employee must not be able to revert to the higher salary at will, and the employee’s contractual arrangements must reflect the revised position. If this is not the case, the taxman will ignore the arrangement and tax the employee as if he or she had continued to receive the higher salary.

Care must also be taken when dealing with employees on low incomes. If cash salary drops below the Lower Earnings Limit for National Insurance purposes (currently £95 per week, but set to increase to £97 per week from 6 April 2010), entitlement to statutory payments and the basic state pension may be jeopardised.

It is also worth noting that where non-cash benefits are provided, the employer must maintain these throughout an employee’s maternity leave.

Tax Credits Claimants

Kelly Sizer, Technical Officer for the Low Incomes Tax Reform Group, offers a further word of warning:

“Salary sacrifice arrangements should be approached with extreme caution for taxpayers who are also tax credits claimants.  Childcare vouchers mentioned in this article are a particular hot potato, as many low to middle-income families can find they lose more through the Working Tax Credit childcare element than they gain in tax and NIC savings by taking vouchers.  The key issues are highlighted in LITRG’s previous Taxationweb article: Tax Relief on Childcare Vouchers To Go - a Blessing or a Curse?” 

Time is Running Out

Although HMRC has hitherto accepted salary sacrifice arrangements as legitimate tax planning, there are indications that the tide may turn. After plans to remove tax relief for childcare vouchers where provided under salary sacrifice arrangements were dropped, the Chancellor instead turned his attention to free and subsidised meals. From 6 April 2011, the tax exemption in respect of free and subsidised meals will be lost where these are provided under a salary sacrifice arrangement.

Practical Tip

It is often said that the good times don’t last forever and it may be the case that salary sacrifice schemes have had their day. However, at the moment they are still an excellent way of taking advantage of the various tax exemptions on offer and, for now at least, swapping taxable salary for a tax-exempt benefit remains a worthwhile swap.

The above article is taken from Tax Insider Lite, a free version of Tax Insider, TaxationWeb's own publication specifically for our Taxpayer visitors. Tax Insider is a monthly magazine containing numerous tax tips, articles, questions and answers from leading tax experts, aimed at helping taxpayers to save and reduce tax liabilities.    

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