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Salary Sacrifice

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Salary Sacrifice

What is a salary sacrifice?

A salary sacrifice happens when an employee gives up the right to receive part of their salary due under their contract of employment and as such this is diverted to provide the employee with some form of benefit such as childcare vouchers, pension scheme contributions, permanent health insurance or medical insurance. The ‘sacrifice’ is achieved by varying the employee’s terms and conditions of employment relating to pay; the employee effectively gives up their contractual right to future salary.

For example, an employee’s contract of employment provides that they will receive a basic salary of £30,000 per annum. The employee agrees with their employer that, for the future, they will be paid a salary of £27,400 per annum and 52 childcare vouchers, each with a face value of £50. This would be a salary sacrifice.

An employee may also sacrifice future cash remuneration other than salary, for example a one-off bonus.

What is the role of HM Revenue & Customs (HMRC)?

Whilst salary sacrifice is a matter of employment law, HMRC have an interest in determining how income tax and National Insurance contributions (NICs) apply to the various elements in the employee’s remuneration package. Where a salary sacrifice has been put in place for the purpose of converting salary that is subject to income tax and Class 1 NICs into a non-cash benefit that has a different income tax and NICs treatment (particularly if the benefit is exempt from income tax and NICs), HMRC must be satisfied that the salary sacrifice arrangement is effective. In summary, HMRC is concerned that the correct amount of income tax and NICs is paid in respect of each element of the remuneration package that the employee receives from their employment.

In order to decide whether a salary sacrifice arrangement is effective or not, HMRC has to consider the construction of the revised contractual arrangements. The employer should provide details of the scheme and the new arrangements. HMRC will need to be satisfied that the employee’s entitlement to salary has been reduced, that a non-cash benefit has been provided instead and that the employer is not simply meeting the employee’s own financial commitments. The effect of the contractual change must be that the employee has given up the right to some of their salary in return for the benefit.

The benefits in kind that attract tax and NICs advantages when offered through a salary sacrifice arrangement are now limited following the introduction of new rules in April 2017. Subject to exceptions, benefits in kind (whether taxable or exempt) provided through salary sacrifice will become chargeable to income tax and employer NICs on the greater of the amount of salary sacrificed and the cash equivalent specified by statute (if any). If the usual taxable value of the benefit in kind is higher than the amount of salary sacrificed, it will be subject to tax and Class 1A NICs in the usual manner.

The following benefits in kind are excluded from the new rules:

  • Employer pension contributions.
  • Employer-provided pension advice.
  • Employer-supported childcare.
  • Cycles and cyclist’s safety equipment provided under cycle to work schemes.
  • Ultra-low emission cars (CO2 emissions of 75g/km or less).

The arrangements in relation to these above benefits are therefore unaffected. Salary exchanged for intangible benefits, such as flexible working, additional holiday entitlement and payroll giving are also unaffected.

There are transitional rules for agreements in effect before 6 April 2017 (even if the arrangements take place after this date). Here, the income tax and NICs treatment will be protected as follows:

  • For company cars (with CO2 emissions above 75g/km), accommodation and school fees until 6 April 2021, unless the arrangement is ended, varied or renewed (including auto-renewal) before this date.
  • For all other benefits until 6 April 2018, unless the agreement is ended, varied or renewed before this date.

A variation for these purposes does not include a variation which is required because of replacement as a result of accidental damage (for example following the theft of a company car) or for reasons beyond the control of either party. Moreover, suspension of salary sacrifice during statutory leave (such as statutory sick pay, maternity/paternity/adoption pay or shared parental pay) is not a variation or renewal.

There is no requirement for an employer to inform HMRC that a salary sacrifice arrangement has been adopted. HMRC will not comment on a salary sacrifice scheme before it is set up but they will, on request, confirm the correct tax treatment of the arrangement once it has been put in place.

What is an effective salary sacrifice arrangement?

A salary sacrifice arrangement will be effective when the employee’s contractual right to salary has been reduced. There are two preconditions for this:

  • The potential future remuneration must be given up before it is treated as received by the employee for income tax and NICs purposes – in practice, this means that the contract of employment must be effectively varied well in advance of the date when the first payment under the new arrangement is due to be made.
  • The true construction of the revised contractual arrangement between the parties must be that the employee is now entitled to a lower salary and a non-cash benefit.

The change in the employee’s entitlement should be clearly reflected in the contractual documentation.

However, a salary sacrifice arrangement will not be effective if it enables the employee to continue to be entitled to receive the higher level of salary i.e. he or she has simply asked the employer to apply part of their salary on their behalf in providing the benefit. Salary sacrifice is not a deduction from pay.

If the employee has the right to give up the benefit at any time and revert to the original, higher level of salary, the non-cash benefit may still be taxable as ‘earnings’ and any tax exemption may be lost. However, legislation is in place to prevent this happening for the following exempt benefits:

  • Employer-provided childcare.
  • Workplace parking.
  • Employer-provided cycles.

These three benefits are exempt from income tax altogether and it is not necessary for the employer to stipulate a period for which the arrangement must be entered into or to set out that the salary sacrifice arrangement will only be reviewed where there are ‘lifestyle changes’.

Lifestyle changes

With other benefits, HMRC accepts that certain ‘lifestyle changes’ may justify changing a salary sacrifice arrangement before the intended duration has elapsed. There is no legal definition of what amounts to a lifestyle change, but it is generally intended to refer to unforeseen life events, such as redundancy of a partner, pregnancy of an employee or partner, marriage or divorce of an employee, etc., whereby an employer might agree with the employee to revisit the existing salary sacrifice arrangement to take account of the change in circumstances. This may happen if the employee has a salary sacrifice arrangement for a set period and within that period an event happens that mean the arrangement is no longer suitable.

It would be up to the employer to define what a lifestyle change is in the documentation and whether the parties can agree to end the existing arrangement early in this circumstance.

What considerations are there when setting up a salary sacrifice arrangement?

As an employer, you must understand what the salary sacrifice will mean in practical terms.

A salary sacrifice cannot reduce an employee’s pay below the National Minimum Wage. The only exception is the benefit of accommodation provided by the employer, where a daily offset can apply.

When considering whether to accept a salary sacrifice arrangement, employees also need to consider what effect a reduction in their salary may have on their future right to the original, higher salary, any pension scheme contributions and entitlement to State Pension, means-tested or contributions-based state benefits, tax credits and other earnings-related benefits such as SMP and statutory sick pay (SSP).

Notional salary

It is still possible for you to refer to the original, higher salary as a ‘notional salary’ for certain purposes without it invalidating the salary sacrifice arrangement.  For example, you might still use the notional salary to determine pay increases, pension scheme contributions, to calculate overtime rates and to work out entitlement to holiday pay, etc. It is up to you to decide whether such payments should be based on the notional salary or on the employee’s new, reduced salary and you should make your position clear to the employee (in this case of occupational pension schemes, the scheme rules should be checked to ensure the salary sacrifice arrangement does not fall foul of these if notional salary is to be used).

This document has been created by, or on behalf of ESP Ltd, as a general document and as a guide in relation to its subject matter and has not been bespoke drafted for you or the specific circumstances in which you are looking to use it. Prior to using this document and undertaking any HR process you must consult your organisation’s own policies and procedures to ensure that you do not do anything in conflict with your own policies and procedures.  If in any doubt as to how to use this document or, if you require any legal advice, please feel free to contact ESP Ltd on 0333 006 2929 and our legal team will be more than happy to assist.  ESP Ltd will not be liable in any way for any actions undertaken by you or your use of this document unless we have been consulted regarding your use of this document as legal advisor to your business or have bespoke drafted any documentation in response to a specific support request.