Following on from last month, when we considered the recent judgment of the European Court of Justice in Astra Zeneca UK Ltd v HMRC, dealing with the VAT consequences of a salary sacrifice arrangement, this month we look at the tax treatment of salary sacrifice arrangements more generally.
What is salary sacrifice?
The principle behind most salary sacrifice arrangements is that an employee gives up part of their entitlement to salary or bonus, which would otherwise be subject to income tax and national insurance contributions (NICs), in exchange for a non-cash benefit. This non-cash benefit enjoys a full or partial exemption from income tax and/or NICs. The result is a saving of both employer and employee NICs and, in some cases, income tax as well. The tax and NICs savings are commonly split between both the employer and employee so that both parties benefit from the arrangements. Such arrangements, if properly implemented, are recognised by HMRC as being legitimate tools to remunerate employees and will not be regarded as tax avoidance.
What are common examples of salary sacrifice arrangements?
Salary sacrifice arrangements are commonly used:
- where employers agree to increase their contributions to an employee’s pension;
- where employees wish to increase their contribution to their pension;
- in the provision of childcare vouchers or childcare to employees;
- for the loan of cycles to employees under the “cycle-to-work” scheme;
- for the sale to employees of additional holiday days.
How do we implement them?
This needs to be done carefully as salary sacrifice arrangements will only be effective if they are implemented correctly.
In order to be effective, salary sacrifice arrangements must constitute a variation of the contract of employment. Employees must give up their right to salary or bonus before they are entitled to receive (for tax purposes) such remuneration under the existing contract.
The employment contract can be varied in a number of ways. In particular: the contract can be rewritten in whole or in part; the agreed changes can be set out in a separate document that is attached to the main contract; or (subject to certain conditions) employees can be informed of proposals to make changes by the employer, provided the employee is fully informed of the proposals and given the opportunity to opt out.
Employee’s attention should also be drawn to the fact that reducing earnings and NICs may affect current or future entitlement to state benefits (for example, statutory sick pay, statutory maternity pay, statutory paternity pay, and state pension) and tax credits. This is because an individual’s entitlement to benefits and credits is often based on earnings or the amount of NICs the individual pays.
What is the tax benefit of the most common salary sacrifice arrangements?
- Increased pension contributions
For tax purposes, the effect of replacing a right to an amount of salary with a right to an employer pension contribution is to reduce gross earnings. This reduces both employer and employee NICs. Since there are no employer or employee NICs on employer pension contributions, this results in an absolute NICs saving.
- Childcare vouchers
The first £55 a week of childcare vouchers provided by an employer for qualifying childcare is exempt from tax and NICs. A similar exemption applies where an employer arranges for the provision of qualifying childcare directly. Provided the conditions for the exemption are met, where childcare vouchers or qualifying childcare are provided by way of a salary sacrifice arrangement, the employee saves tax and NICs on any salary sacrificed and the employer enjoys reduced employer NICs.From 6 April 2011, new joiners to childcare voucher schemes will only be entitled to basic rate tax relief. Existing higher and additional rate taxpayers who are already members of such a scheme will be unaffected.
- Cycle to work
Provided all the qualifying conditions are satisfied, an employer may loan cycles and cyclists’ safety equipment to employees as a tax and NICs free benefit. Where this benefit is provided by way of salary sacrifice, the employee therefore saves tax and NICs on the salary sacrificed and the employer saves employer NICs. Particular care must be taken to ensure that the employee pays a fair market value for the cycle (and any safety equipment) at the end of the rental period.
- Additional holiday days
For tax purposes, the effect of replacing a right to an amount of salary with a right to additional holiday days is simply to reduce gross earnings, and therefore income tax and both employer and employee NICs (since the provision of additional holiday days is not a taxable benefit).
What is the effect on salary-related cash benefits?
While employees may agree to reduce their salaries in return for non-cash benefits, they may wish to maintain other salary-related benefits at their previous pre-salary sacrifice levels. It is generally possible to specify a “shadow” salary for other remuneration and benefit purposes such as:
- death-in-service benefits;
- pay-related allowances, such as overtime;
- future pay increases;
- payments in connection with termination of employment, such as pay in lieu of notice; holiday pay or redundancy pay.
As a general rule, the cost to the employer of providing non-cash benefits to employees should, like any salary paid to an employee, be fully allowable as a deduction for corporation tax purposes. Special rules as to the timing of deductions may apply in the case of pension contributions.
Where salary sacrifice arrangements are considered, it is important to seek tax advice on whether any tax disclosures need to be made under the tax or NICs disclosure rules. No disclosure is likely to be necessary for commonly used arrangements such as the ones set out above.
Further, as was demonstrated in last month’s article, it is important to ensure that there are no adverse VAT consequences of the provision of a non-cash benefit.
In each case where a salary sacrifice arrangement is considered, it is important to get tax advice to ensure that the arrangements are implemented correctly, work as intended, and do not result in any adverse consequences, such as VAT, on the provision of the benefit.
Emma Bailey is a Partner and Jaspal Pachu an Associate, both specialising in tax at Fox Williams LLP. They can be contacted on firstname.lastname@example.org and email@example.com