Salary sacrifice schemes can be an effective means of saving precious cash, but employers must make sure they measure up to HMRC standards. Ken Gurr looks at how to avoid exposure to penalties.
A salary sacrifice happens when an employee gives up the right to receive part of the cash pay due under their contract of employment in return for the employer’s agreement to provide the employee with some form of non-cash benefit. The purpose of salary sacrifice is to save the employee and employer money.
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.
However, salary sacrifice is commonly used by employers or employees to take advantage of the statutory exemptions from tax and/or NI of certain benefits.
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. Therefore, the first important lesson is to appreciate that for a salary sacrifice to be effective there must be a contractual change.
Example: salary sacrifice for childcare vouchers
An employee’s current contract provides for cash remuneration of £40,000 a year with no benefits. Therefore the employee will pay tax and National Insurance on the £40,000 each year.
The employee agrees with the employer that for the future the employee will be
paid £37,140 a year plus 52 childcare vouchers each with a face value of £55.
Because the childcare vouchers of £55 per week are exempt from tax and NI, the employee will only pay tax and NI on £37,140 in the year in future.
Assuming a tax rate of 20% and NI rate of 11%, this represents an annual saving in tax and NI of £40,000 – £37,140 = £2,860 x 31% = £886.60
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 the employee merely asked the employer to apply part of that cash remuneration on his or her behalf.
Care in setting up a salary sacrifice scheme
HMRC will not help employers set up a salary sacrifice scheme because their argument is that they are a matter of employment law and not tax law. However, if not set up correctly, the employer could find themselves responsible for the tax and NI not deducted from the employer liability.
So, what should employers take into consideration?
- Reversion to original salary. If an employee has a right to return to the original cash salary, the salary sacrifice scheme is not effective. The change to the lower cash salary must be a permanent contractual change. There can be no guarantee of the original salary being reinstated. However, HMRC do accept that an annual review will not make the scheme ineffective.
- Future salary increases and overtime rates. After entering into a salary sacrifice arrangement, an employee’s salary is contractually lower than it was before. When the employee is due a salary rise, it might be expected that the increase be based on the new lower salary. In practice, the increase can be based on the former salary, as long as the salary sacrifice is preserved. Salary increases are a contractual matter between employer and employee and, if the employer wishes to give a higher or lower increase to a particular employee, that is for the employer to decide.
- Pension contributions. Employer and employee contributions are commonly a percentage of each employee’s ‘pensionable earnings’. Employers need to make sure the pension provider is happy with any salary sacrifice arrangements. Can pension contributions be based on a notional salary figure? Any reduction in pension contributions can have an impact on future pension entitlement.
- Tax credits. Salary sacrifice arrangements can impact on an employee’s entitlement to tax credits. Therefore, employees should be advised to check before entering a scheme.
- National Minimum Wage. No employee should be allowed to enter into a salary sacrifice arrangement that reduces their pay below the National Minimum Wage .
- Contributory benefits. A reduction in salary could take an employee’s earnings below the NI lower earnings limit. Should this be the case, the employee no longer has earnings which count towards either state or work related benefits such as basic state pension, state second pension, employment support allowance, maternity allowance and all of the employment related benefits such as SSP, SMP, SAP and SPP.
- Maternity leave. During her maternity leave, an employee is entitled to receive all the benefits under her contract, as if she were working, with the exception of remuneration (wages or salary). Therefore she must continue to receive the benefit during her leave but no deductions may be made from SMP. An employer may only deduct from any excess contractual payment.
- Length of the contract. There is no minimum term, however, HMRC usually look for a minimum period of one year before the contract can be revisited. Having said that employers can build into their schemes a proviso that the contract may be revisited if there is a lifestyle change such as redundancy, pregnancy, etc. It is also highly recommended that employers build in a re-entry criteria to prevent employees leaving and re-entering the scheme within very short periods of time.
Example: cycle to work scheme
Purpose of the scheme
To promote healthier journeys to work and to reduce environmental pollution, the 1999 Finance Act introduced an annual tax exemption, which allows employers to loan cycles and cyclists’ safety equipment to employees as a tax-free benefit. Under section 244 of the Income Tax (Earnings and Pensions) Act of 2003 no liability for income tax arises on the provision of cycles or cyclist’s safety equipment that is placed at the disposal of an employee if
- the employee uses the cycle or equipment in question ‘mainly’ for ‘qualifying journeys’, and
- cycles and/or cyclist’s safety equipment are available generally to employees of the employer.
A ‘qualifying journey’ is the whole or part of a journey
- between the employee’s home and workplace, or
- between one workplace and another,
in connection with the performance of the duties of the employment.
The term ‘mainly’ is not defined in any legislation and HMRC accepts that the test is satisfied
unless there is clear evidence that less than half of the use is on qualifying journeys.
There is no requirement for employers or employees to keep mileage logs.
The salary sacrifice
This exemption is the basis for a salary sacrifice scheme, whereby the employee contractually gives up a part of their salary in exchange for the provision of a cycle and related equipment on loan that qualifies for the exemption.
Providing these criteria are met, there is no tax or NI liability on the employee at all. The employer saving is the Class 1A NI that would have been payable had the benefit not been exempt.
So, employers need to be clear with employees on the contractual implications of being provided with the bicycle.
- Ownership of the bicycle. The bicycle remains the property of the employer throughout the length of the scheme. The scheme is ineffective if the employee takes ownership of the bicycle. To prevent an excessive tax charge arising if, at the end of the period of loan period, the employee buys the cycle and related equipment, a special exemption is available that limits the tax charge to the their market value when title is transferred to the employee.
- Withdrawal from the scheme or termination of employment. The consequences for withdrawing from the Cycle to Work scheme will depend on the terms of the agreement for the loan of the equipment. This is a matter for the employer and employee to agree. Employers need to make clear any compensatory payments that may have to be made by the employee if the contract is terminated early.
- Length of the scheme. There is no set period, however, employer’s may be swayed to consider that the scheme should not run for longer than 18 months. The reason for this being that s101 of the Consumer Credit Act gives the employee an absolute right to terminate the arrangement after 18 months.
- Insurance. Because the bicycle is owned by the employer or provider, it is strongly suggested that clarity is needed in contracts as to who is responsible for insuring the bicycle. Employers need to ask who is responsible if the bicycle is stolen and whether the employee is responsible for completing the payments up to the contract end date.
- Price of bicycle. Bicycles can prove very costly. It is therefore recommended that employers set a threshold price for the bicycle and equipment to avoid disputes at a future date.
- What if the employee does not want to buy the bicycle at the end of the contract? The contract needs to make it clear what the purchase terms are and any disposal costs that may be made if the employee chooses not to buy the bicycle.
- Who actually provides the bicycle in the first place? Most employers enter into an arrangement with a participating shop or provider. A search on the internet will come up with several providers if the criteria are set as ‘cycle to work scheme salary sacrifice’.
- Who is responsible for maintaining the bicycle? The contract should make it very clear whether it is the employee’s or employer’s liability.
See also: On Your Bike! Published in The People Bulletin on 22 April 2009