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Sarah Laing CTA outlines the income tax and National Insurance implications and potential benefits of salary sacrifice schemes, and highlights the conditions to be satisfied.

Sarah Laing

Mutual benefit

Salary sacrifice schemes can prove beneficial to both employers and employees and are becoming an increasingly popular part of employee remuneration packages.

Broadly, such schemes involve the employee effectively swapping cash salary or wages, which attract both tax and National Insurance Contributions (NICs), for exempt benefits. The overall effect is that employers can offer remuneration packages tailored to employee needs, without increasing (and often decreasing) their overall payroll costs. For example, if an employee pays for childcare, and sacrifices £55 per week of gross salary for £55 of exempt childcare vouchers, his overall remuneration package will be the same. However, if the employee is a basic rate taxpayer, he will save tax of £11 per week and NIC of £6.05 by making the swap. The employer will also save secondary Class 1 NIC of £7.04.

Implications

However, as is the norm with anything to do with tax, life is never that simple and there are a number of knock-on effects that need to be considered before entering into a salary sacrifice arrangement. HMRC have recently published a document explaining how salary sacrifice works and the impact it has on income tax, National Insurance contributions, the national minimum wage, contributory benefits, statutory payments and tax credits. The document can be downloaded from the HMRC website at http://www.hmrc.gov.uk/specialist/salary_sacrifice.pdf.

The most important thing to remember is that salary sacrifice is a matter of employment law, not tax law. Where an employee agrees to a salary sacrifice in return for a non-cash benefit, they give up their contractual right to future cash remuneration. Employers and employees who are thinking of entering into such arrangements would be well advised to obtain legal advice on whether their proposed arrangements achieve their desired result.

Effective arrangements

Many payments and benefits are treated in the same way for both tax and NICs. However, in some cases, where a particular benefit may be exempt from tax and/or NICs or subject to Class 1A NICs, the tax and NICs outcome will be different.

If a salary sacrifice arrangement is entered into to convert cash salary that is subject to tax and National Insurance to a benefit that has a different tax and National Insurance treatment, HMRC need to be satisfied that the salary sacrifice is effective. The effect of the contractual change must be that the employee has given up the right to some of their cash pay in return for the benefit. HMRC can only deal with the replacement benefit under the employee benefit legislation if they are happy that there has actually been a contractual change.

For this change to happen, two conditions have to be met:

• the potential future remuneration must be given up before it is treated as received for tax or NICs purposes; and
• the true construction of the revised contractual arrangement between employer and employee must be that the employee is entitled to lower cash remuneration and a benefit.

A salary sacrifice is not effective if, in practice, the arrangement enables the employee to continue to be entitled to the higher level of cash remuneration. In other words, if he has merely asked the employer to apply part of that cash remuneration on his behalf.

In order for HMRC to decide whether a salary sacrifice is effective, the employer needs to provide full details of the scheme and of the new contractual arrangements. The employer will need to satisfy HMRC that the employee’s pay has actually been reduced and that a benefit has been provided instead.

Considerations

Before entering into a salary sacrifice arrangement employees should carefully consider the effect, or potential effect, that a reduction in pay may have on:

• their future right to the original (higher) cash salary;
• any pension scheme being contributed to;
• entitlement to Working Tax Credit (WTC) or Child Tax Credit (CTC); and
• entitlement to state retirement pension or to other benefits such as statutory maternity pay.

State benefits

Where cash pay is sacrificed in return for a benefit that is exempt from NICs, for example, childcare vouchers, no NICs are due on the cost of providing the vouchers. Although this means that both the employer and employee save NICs, and the employee can therefore get more vouchers than cash for the same cost to the employer, it also cuts the earnings on which the employee can pay NICs. It may also take the employee’s earnings for which NICs are due below the lower earnings limit (LEL), which is £90 per week for 2008/09. Since entitlement to some benefits is based on NICs paid, and others on earnings, entering into a salary sacrifice may affect current or future entitlement to a range of benefits. It is particularly important to note that not only will entitlement to the state second pension (S2P) be affected if reduced earnings fall below the LEL, but it may also be affected if the employee’s reduced earnings fall between the LEL and the upper earnings limit (UEL) (£40,040 in 2008/09).

Tax credits

By contrast, entering into a salary sacrifice arrangement may increase entitlement to tax credits. Swapping taxable salary for an exempt benefit such as childcare vouchers, may reduce the employee’s relevant pay for tax credit purposes as the value of the benefits is not included in the calculation of income. This in turn, could increase the employee’s working tax credit award. However, if the replacement benefit is childcare provision or childcare vouchers, the childcare element of a working tax credit award may be reduced.

Pension contributions

The amount that an employee can contribute to a pension scheme will be reduced if his earnings are reduced under a salary sacrifice arrangement. This will also be the case if the employee pays a set percentage of earnings into his employer’s pension scheme. In addition, any associated employer contributions may be reduced. This could adversely affect the employee’s future pension entitlement and should therefore be considered carefully.

National Minimum Wage

Employers are legally obliged  to pay employees a minimum amount of pay that is at least equal to the National Minimum Wage (NMW) and consequently a salary sacrifice arrangement cannot reduce the employee’s cash pay below the NMW (currently £5.52 per hour). The value of the substituted benefit is not taken into account in determining whether the employer’s obligations in relation to the NMW have been met.

Summary

Salary sacrifice arrangements can be an effective way of allowing employees to benefit from exemptions available on certain benefits without requiring the employer to meet the cost of providing those benefits. Broadly, the employee can choose to swap cash salary for an exempt benefit, thereby saving tax and NICs that would have been payable had the employee simply paid for the benefit from his post-tax salary.

However, it is essential to look further than the mere tax and NICs savings. Anyone thinking about entering into a salary sacrifice scheme also needs to think about the impact on entitlement to future contributory and non-contributory benefits, pensions and tax credits. The employer must also pay close attention to the national minimum wage legislation to ensure that a salary sacrifice arrangement would not put him in breach of these rules.