Salary Sacrifice (or Exchange) is an agreement which saves employee income tax and/or employee/employer National Insurance Contribution’s and can produce the same pension contribution at a lower net cost, or a higher pension contribution at the same net cost.
Salary Sacrifice is an agreement between an employee and their employer. The employee agrees to exchange part of their gross (before tax) salary in return for a non-cash benefit, like a pension contribution.
Reducing salary results in a saving in individual income tax and employee and employer national insurance contributions. As a result of the savings, when compared with the employee making personal pension contributions, salary sacrifice can produce the same pension contribution at a lower net cost, or a higher pension contribution at the same net cost.
There are however a number of potential drawbacks including no guarantee that the higher salary entitlement will be returned in future as well as the possible impact on certain benefits and borrowing potential.
'Salary sacrifice' is the one term in the financial planning business that labours under a very unflattering and unfair terminology. Moving salary to work harder and smarter for a client and/or their employer seems to be salary ’re-worked' rather than salary sacrificed. Maybe this is why it's often referred to as salary exchange.
Cash bonuses can similarly be sacrificed for the purposes of this section, salary and bonus are interchangeable terms unless specifically stated otherwise.
This section looks at the mechanics of salary sacrifice.
The diagram below summarises the rates, bands and allowances for income tax and NI for 2020/21:
Scottish taxpayers will pay the Scottish rate of income tax (SRIT) on non-savings and non-dividend (NSND) income. NSND income includes employment income, profits from self-employment (including sole trades and partnerships), rental profits, and pension income (including the state pension). Similarly, from 6 April 2019 Welsh Taxpayers pay the Welsh Rate of Income Tax (CRIT (C for Cymru)) on NSND income.
Other tax and deductions such as Corporation Tax, dividends, savings income and National Insurance Contributions etc. will remain based on UK rules. This could mean the amount of income tax relief which can be claimed on pension contributions by Scottish and UK tax payers may not be the same. For more info on SRIT and how this works in practice, please visit our facts page. For more info on CRIT and how this works in practice, please visit our facts page.
Most employees and employers are aware that individual pension contributions get tax relief at the employee's marginal rate and as such pension contributions effectively reclaim the income tax paid by the individual on the portion of the earnings subsequently invested into a pension. However, there is no relief given on the employee National Insurance Contributions (NIC) that have been deducted from the employee’s income, prior to it being invested into a pension via individual contribution (nor does the employer receive any relief on the NI the employer paid on the salary that the employee subsequently paid into their pension). On the other hand, any employer pension contributions are made directly by the company (are relievable against the company’s Corporation tax bill as a business expense) and are not subject to employer NIC’s. The member will have no liability to NI when taking income from the pension, but may be subject to income tax at their marginal rates at that time.
If only there was a way for an individual to give up the earnings they were going to invest into individual pension contributions, in return for an equivalent employers pension contribution, so that relief from NIC on the money being invested into pension could also be gained…
What is Salary Sacrifice?
Quite simply a sacrifice happens when an employee gives up their right to part of their salary, in return for a non-cash benefit which is normally exempt from tax and / or NI. It's usually, but not exclusively, an employer pension contribution. Although as detailed in HMRC's view on salary sacrifice later, there are restrictions on sacrificing for non-pension benefits.
The cornerstone of sacrifice is a legally binding variation of the employment contract where the employee gives up their right to future cash remuneration. In the past the sacrifice had to be effective for at least 12 months and the employee did not have the right to revert to cash remuneration.
However, due to the advent of auto enrolment in October 2012 and its correlation with salary sacrifice rules, HMRC amended their guidance to remove the 12 month requirement where sacrifice was set up for employer contributions to a registered pension scheme.
If an employee wants to opt in or out of a salary sacrifice arrangement, employers must alter their contract with each change. The employee’s contract must be clear on what their cash and non-cash entitlements are at any given time. It may be necessary to change the terms of a salary sacrifice arrangement where a ‘lifestyle change’ significantly alters an employee’s financial circumstances. Examples include marriage, divorce, an employee’s spouse or partner becoming redundant, or perhaps an increase in the size of the family following birth/adoption/step-children etc. Salary sacrifice arrangements can allow opting in or out in the event of lifestyle changes like these. However, if the employee can swap between cash earnings and non-cash benefits whenever they like, HMRC are likely to conclude that any expected tax and NIC advantages under a salary sacrifice scheme won’t apply.
Why do it?
In a nutshell, the:
employee has a reduced income tax and NI liability
employer has a reduced NI liability
These combined savings have the impact of 'enhancing' the pension provision either by:
allowing equivalent pension contributions at a lower cost, i.e. more 'take home pay', or
larger pension contributions without extra cost.
A key point is the employer's NI savings. These could be retained by the employer, reducing their costs or passed fully to the member amplifying the benefits, or shared.
In each case there should be no increased cost to the employer of funding the employees' remuneration packages (excepting any costs of arranging it).
What are the drawbacks?
Knock-on implications vary. These include:
no guarantee that the higher salary entitlement will be returned in future
a reduction in earnings-related state benefits
impact on tax credits
impact on any other employer pension provision if this were to be based on the lower cash remuneration
there will potentially be an impact on what the employee can then borrow in terms of a mortgage or loan if the lender uses the post sacrifice salary for income multiples.
Sacrifice may not be allowed if the post sacrifice salary was lower than the National Minimum Wage. However those exempt from the requirement of NMW i.e. those that are not 'worker' i.e. such as directors could sacrifice below this amount.
We also need to be mindful of the fact that any ‘new’ salary sacrifices made after 8 July 2015 will be added back in the calculation of ‘threshold income’ for the purposes of the tapered annual allowance for higher earners. As well as ‘new’ salary sacrifice arrangements, this may also have an impact on salary sacrifice schemes that were in place prior to the 8 July 2015, if the existing arrangements are reviewed and/or if the individual is required to make an annual declaration.
Many would be forgiven in thinking that HMRC would be involved as this is tax avoidance.
On the contrary HMRC are unequivocal in Employment Income Manual (EIM42752):
"Salary sacrifice is commonly used by employers or employees to take advantage of the exemption from tax or NIC or both of certain benefits. It is important to recognise that employers and employees have the right to arrange the terms and conditions of their employment and to enjoy the statutory tax and NIC treatment that applies to each element in the remuneration package. Arrangements, which are designed to make use of these exemptions, should not be regarded as avoidance."
Despite the above, in the 2016 Budget, the government announced they would consult on limiting the advantages of Salary Sacrifice. Following this, legislation was introduced in Finance Act 2017 to introduce a rule to value all Benefits in Kind at the higher of the cash forgone or the current taxable value and remove a number of exemptions previously provided by Part 4 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA). However, it is important to note that the following exemptions will not be affected by this change:
employer provided pension saving
employer provided pensions advice
directly contracted childcare
cycle to work schemes
Ultra-Low Emission Vehicles emitting 75g CO2/km or less
Contracts remained under the pre-2017 rules until the contract ended, was modified or changed or renewed, or April 2018 at the latest. However, the April 2018 deadline is extended to April 2021 for cars, accommodation and school fees.
HMRC gets involved in proposed transactions in very limited circumstances. They do not pre authorise or approve salary sacrifice arrangements. As salary sacrifice is related to employment law and not tax law it would be inappropriate for HMRC to get involved in the contractual relations between an employer and their employee.
While there is no obligation to 'declare' any arrangements set up, an employer can send details to HMRC which would check if the arrangement created an effective salary sacrifice.
HMRC is only concerned with the correct application of relevant tax and NI legislation to the remuneration package.