Salary Sacrifice - getting the basics right

Even the name conjures up fear and confusion with employers and employees and yet the basic concept of exchanging pay for employer provided benefits and less tax seems remarkably sensible. Getting a clear view of the basics is key to understanding - the process can be simple and good for all concerned.

What is a salary sacrifice?

HMRC have a specialist publication called Salary Sacrifice Guidance where they define salary sacrifice as follows:

"A salary sacrifice happens when an employee gives up the right to receive part of the cash pay due under his or her contract of employment. Usually the sacrifice is made in return for the employer's agreement to provide the employee with some form of non-cash benefit. The sacrifice is achieved by varying the employee's terms and conditions of employment relating to pay.

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."

In terms of making an effective salary sacrifice, there are 2 requirements that need to be adhered to, which are:

1. The revised salary agreement must be contractual and not allow a switch back to the previous level of salary, i.e. it must be a formal change.
2. The potential future remuneration must be given up before it is treated as received for tax or NIC purposes, usually this means an arrangement must be in place before pay day of the month it becomes effective.

In addition, the employee should not be able, at their own discretion, to change the arrangement once in place. Therefore, in the case of flexible benefit arrangements, most plans provide for a mix of cash and benefits that can only be changed at specific times, for example the annual pay review, or at agreed "Lifestyle events" e.g. marriage, birth etc.

Impact of Salary Sacrifice

The reduced salary will be subject to less tax and National Insurance, both for the employer and employee. However, the employee is likely to have to pay some tax on the value of the benefits they receive (some are taxable and some are not) through the benefit-in-kind tax system. The employer will also be caught by the Class 1A National Insurance, charged in respect of certain benefits provided to employees. However, National Insurance savings for the employee should remain assuming the benefits are structured correctly .

Be careful that all benefits are employer provided and not simply in the name of the employee. If the employer is just paying for employee owned benefits, HMRC is likely to treat the payments in the same way as salary and the NI savings will be lost.

The impact of formally reducing a salary as described above does have some non-obvious consequences and information to employees needs to be clear to make sure that decisions are made without any nasty surprises coming to light after the event. Areas to think about are:

• Tax Credits - a reduction in salary may increase the amount of tax credits to which an employee is entitled, although the calculations are complex and the effect is not always positive. For example, an employee opting for childcare vouchers under a flex plan will lose the ability to reclaim a proportion of their own childcare costs.
• Statutory benefits - a reduction in salary may reduce the levels of statutory maternity pay. Other contributory benefits may also be impacted (e.g. job seekers allowance, incapacity benefit).
• Pensions - Earnings related State pensions are likely to be reduced (although not always). The value used to base a salary related pension on must also be considered. It is common to use a pre-sacrifice "reference salary" for the calculation of pensions and other salary related benefits.
• Mortgage income multiples - whilst some lenders use newer affordability tests, a lower salary could mean less borrowing capacity.

Summary

A salary sacrifice is a formal reduction in salary in exchange for an equivalent value of non-salary related benefits. This can have some tax advantages but also some potentially negative consequences and it is important to ensure that employees are well informed so that they can make the right decisions.

Our recommendation is that you obtain advice about setting up this type of salary arrangement and make sure your employees have access to good information. It is relatively simple to put in place and operate assuming you get the basics right. If you are putting in place a flexible benefit plan, make sure the adviser has experience in this area.