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 an arrangement would be well advised to obtain legal advice on whether the proposed arrangement achieves the desired result.
Any change in the remuneration package may change:
a) The operation of PAYE.
b) The amount of tax due.
c) The amount of NIC due.
d) A tax credit award.
A salary sacrifice often replaces cash with a benefit. For example an employer can arrange to contribute part of the employees remuneration to an employers pension scheme or arrange childcare vouchers both of which obtain favourable tax and national insurance advantages.
When is a salary sacrifice effective?
Salary sacrifice arrangements are effective when the contractual right to cash pay has been reduced. For that to happen two conditions have to be met:
a) The potential future remuneration must be given up before it is treated as received for tax and national insurance contribution’s purposes.
b) 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.
When is a salary sacrifice not effective?
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 he has merely asked the employer to apply part of that cash remuneration on his behalf.
Employees should carefully consider the effect of a salary sacrifice arrangement to replace cash pay with a benefit that is tax and/or NIC’s exempt. It is important to understand what the arrangement will mean in practical terms. Employees should consider the following:
a) The future right to the original (higher) cash salary.
b) Any pension scheme being contributed to.
c) Entitlement to Working Tax Credit or Child Tax Credit.
d) Entitlement to State Pension or other benefits e.g. Statutory Maternity Pay.
A salary sacrifice cannot reduce an employee’s cash pay below the National Minimum Wage.
Conditions for Successful Sacrifice
The first condition concerns the timing of the changes to the employment contract. Entitlement to future remuneration must be given up before it is treated as received for employment income purposes. This means that the employee must agree to vary the employment contract well in advance of the date of the first payment under which the new arrangement is due to be made. If the contractual changes have not been completed by that date the terms of the previous contract continue to be in force. The employee is still entitled to receive, and is therefore taxable on, the previous higher salary, even though the smaller, post- sacrifice amount is paid.
Entitlement to Cash:
This looks at the true construction of the revised contractual arrangement. There must be a genuine reduction in the cash entitlement in exchange for a non cash benefit.
Right to Revert to Original Salary:
Under contract law and employment law, the terms and conditions of an employment contract may be varied as often as the parties to that contract, that is the employee and the employer, choose. A contract can be legally effective for a stated period of time.
If the employee is able to give up the benefit at any time and return to the original higher cash salary then as he can convert the benefit into cash, that benefit has “money’s worth” for the purposes of income tax. Money’s worth is earnings for income tax purposes. The employee is therefore liable on the higher cash salary and the sacrifice would not be successful.
Effectiveness of Contractual Arrangement
The following aspects should be considered when deciding if the scheme is effective
• What is the date of the change in the remuneration package? Changes cannot be retrospective.
• Has the employee’s contractual entitlement to cash been reduced and replaced with a benefit?
• Is there the right within the contract to return to the original remuneration package?
• Is the benefit exempt from charge to income tax or just exempt under the benefits code?
• Does the provided benefit satisfy the conditions for exemption from tax and/or NIC?
• Has the scheme been implemented?
• Is the correct amount of tax and NIC being accounted for?
• The National Minimum Wage (NMW) is a consideration, as the cash wage should not fall below a set figure. Apart from living accommodation, benefits in kind do not count towards the national minimum wage. It makes no difference whether or not the benefit is taxed.
A successful salary sacrifice should be reflected in the employees payslip information however some payroll software is unable to alter details of gross pay and the sacrificed amount is often shown as a deduction before tax and national insurance is applied.
Example of a Successful Salary Sacrifice
A senior employee is contractually entitled each year to a bonus based on profits made by his employer. The company’s year end is March and the accounts are finalised in September each year giving the amount of the bonus due. The employee is not entitled to receive the bonus each year until 31 December and is informed by letter on 31 October. The letter informs the employee that he can choose between:
a) Receiving the cash bonus; or
b) Giving up his contractual rights to the cash bonus in return for the company making an employer contribution to a registered pension scheme for his benefit.
The employee decides to take the second option and returns the completed documentation to his employer on 30 November. The documentation makes it clear that the employee is giving up his contractual right to the bonus and he does not have the right to change his mind on the decision.
This is a successful salary sacrifice arrangement as the bonus would have become earnings on 31 December, it is given up before that date and the employee has given up cash remuneration in return for a non cash benefit.
Other Points to Consider
Providing Information to HMRC
HMRC will not give advice or comment on particular arrangements except in very limited circumstances. The limited circumstances are set out in the booklet Code of Practice 10 – Information and Guidance. It is not appropriate for HMRC to give advice on contractual arrangements between employer and employee.
There is also no requirement for employers to notify HMRC of a salary sacrifice arrangement however employers can seek the assurance of HMRC that they are accounting for the tax and national insurance issues correctly. Any agreement is given on the understanding that it will cease to apply if there are any further changes to the employment contract.
When considering the various non cash benefits each should be looked at in detail to ascertain the tax and national insurance implications of each salary sacrifice arrangement together with the effect on State Benefits and pensions etc. The above guidance has given a starting point for employers, employees and their advisors.
For any further information on Employment Law, orany of the issues outlined in this piece, please call the Advice Service on 01455 852555.