Innes Reid Investments Limited

What is salary or bonus sacrifice?

A salary or bonus sacrifice involves an employee agreeing to change their terms and conditions of employment relating to pay. Under their revised employment contract, the employee is entitled to a lower salary or contractual bonus than before, plus a new non-cash benefit from their employer. Normally, this is done to create tax or National Insurance savings without reducing the overall value of an individual's benefit package. To have legal effect, it's important that the contract change meets certain HMRC requirements.

Note that if there's not a contractual right to a bonus, HMRC doesn't view this as a sacrifice. So, there's no need for an exchange of letters between employer and employee.

Why use salary or bonus sacrifice for pension funding?

Using an effective salary or bonus sacrifice arrangement to fund an employee's pension, rather than the employee paying pension contributions from their salary, can produce significant financial benefits for both the employee and employer (although there can also be drawbacks in some circumstances).

Where a salary or bonus sacrifice arrangement is valid, the pension contributions funded by the sacrifice are treated as an employer contributions. Tax relief on the contribution should be allowed as a business expense in the same way as any employer contribution, but it is up to the local Inspector of Taxes.

Employee benefits from salary or bonus sacrifice

Cutting an employee's earnings usually means they'll pay less income tax and National Insurance (NI) than before.

Because employee pension contributions qualify for tax relief anyway, using salary or bonus sacrifice to fund an employer pension contribution doesn't produce an income tax saving. However:

• Where employee pension contributions are paid under the relief at source system (as applies to personal pensions and SIPPs), using a sacrifice agreement to fund the pension instead has the advantage of effectively giving the benefit of any higher rate tax relief immediately.
• Also, because there's an NI saving from an effective sacrifice agreement, the same pension contribution can be made at less cost to the employee - giving them a larger net take home pay. Alternatively, a larger pension contribution can be made without affecting the employee's net take home pay. This in turn saves more NI, but also now creates a saving in tax, which allows a greater sacrifice...and so it continues.

Employer benefits from salary or bonus sacrifice

Cutting an employee's earnings usually means the employer will pay less NI than before.

• An employer has to pay National Insurance on all earnings above theearnings threshold, so the employer will normally see a saving of 13.8% of the sacrificed amount. If the employee is contracted out of the State Second Pension under an occupational pension scheme, the saving reduces to 10.1% (defined benefit) or 12.4% (money purchase) on earnings between theearnings threshold and the upper accrual point.
• Employers often agree to share part of this saving with the employee, for example by way of a boost to their pension contribution for the employee, to increase the appeal of the salary or bonus sacrifice facility.

Example: the benefits of salary sacrifice

Consider an employee earning £25,000 for the tax year 2011/12, who wants to contribute £100 a month (gross) to his Pension Plan. Table 1 below shows three different ways of funding the Pension Plan contribution and how the employee can benefit by using salary sacrifice.

• Column A shows the position if the employee makes the contributions personally from salary.
• Column B shows the position if the employee's salary is cut by the amount of the gross contribution, which the employer pays into the Pension Plan. This gives the same pension contribution, but leaves the employee with more take home pay.
• Column C shows the position if the employee's salary is cut to the amount which leaves the same take home pay, with the employer paying the sacrificed salary into the Pension Plan. This gives a larger pension contribution without affecting the employee's take home pay.

Table 1 - how the employee can benefit:

	A	B	C
Salary	£25,000	£23,800	£23,588
Personal allowance	£7,475	£7,475	£7,475
Taxable income	£17,525	£16,325	£16,113
Tax payable	£3,505	£3,265	£3,223
National Insurance	£2,133	£1,989	£1,963
Net salary	£19,362	£18,546	£18,402
Pension contributions (net)	£960	Nil	Nil
Spendable income	£18,402	£18,546	£18,402

Summary:

	A	B	C
Pension contribution (gross)	£1,200	£1,200	£1,412
Increase in take home pay	Nil	£144	Nil
Increase in pension contribution (gross)	Nil	Nil	£212

Table 2 shows the employer's position for each of the three options and the amount of employer National Insurance that can be saved.

Table 2 - how the employer can benefit:

Employer costs	A	B	C
Salary	£25,000	£23,800	£23,588
National Insurance	£2,474	£2,308	£2,279
Pension contribution (gross)	Nil	£1,200	£1,412
Total	£27,474	£27,308	£27,279
Reduction in outlay	Nil	£166	£195

What are HMRC's requirements for a valid salary or bonus sacrifice arrangement?

An effective salary or bonus sacrifice arrangement must meet certain HMRC requirements:

• The employee's contractual right to cash remuneration must have been reduced in return for a non-cash employee benefit; and
• The employee must not have the right to revert to the higher cash salary whenever they want.

The employee's terms of employment must be changed before the salary or bonus sacrifice arrangement commences. In other words, the employee's right to the higher salary or bonus must be given up before it is treated as received for income tax or National Insurance purposes - it can't be done after the event.

The agreement can be documented as either a permanent contract change or a temporary change for a stated period of at least 12 months. If an employee reverts back to the pre sacrifice pay within 12 months of the arrangement being established, or has the right to revert to the pre sacrifice pay whenever they want, this wouldn't be considered to be a valid sacrifice.

Neither employers nor employees need to inform HMRC of any salary or bonus sacrifice arrangements that they adopt. In practice, however, many employers ask HMRC to comment to reassure themselves that the arrangements have been implemented properly and that they are accounting for the correct amount of income tax and NI.

What are the consequences if HMRC decide that a salary or bonus sacrifice isn't valid?

If HMRC decides that a salary or bonus sacrifice agreement isn't valid, it will treat the amount sacrificed as if it had been paid to the employee as earnings. This means the employee will be subject to income tax on the earnings they tried to sacrifice and both the employee and employer will be subject to National Insurance.

Where the invalidly 'sacrificed' earnings have been paid to a pension scheme, this will be treated as a pension contribution made by the employee. This will qualify for tax relief, subject to the usual rules and limits, but it doesn't reduce the National Insurance liability.

How should salary or bonus sacrifice arrangements be documented?

To be effective for tax and National Insurance purposes, a salary or bonus sacrifice arrangement must result in a legally binding change to the employee's contract of employment.

The most common method of documenting a change to an employee's contract of employment for the purposes of salary or bonus sacrifice is by the employee and employer agreeing to the change in an exchange of letters. It should mention both the reduction in salary and the non-cash benefit to be provided instead.

Will employer contributions under salary or bonus sacrifice always qualify for tax relief?

HMRC has confirmed in BIM46075 of their Business Income Manual that, where an employer pension contribution is funded from a valid salary or bonus sacrifice arrangement, it will automatically pass the wholly and exclusively test and be allowed as a deduction in calculating the employer's taxable profits.

Are there any drawbacks to salary sacrifice?

There can be drawbacks to entering a salary sacrifice arrangement, for example:

• The employee might not be able to revert to their oldpre salary sacrificeif their circumstances change.
• The employee's ability to borrow could be reduced following their salary cut. This could affect the levels of mortgage, personal loan or credit card limit they can get. There are, however,some lenders who will base their calculations on the notional (before sacrifice) salary.
• Other salary related elements of the individual's employment package, such as contractual pension contributions, life assurance cover, PHI cover, overtime pay or future salary rises, may be affected by the salary sacrifice.

Does salary sacrifice affect other aspects of an individual's employment package?

Salary sacrifice involves an employee agreeing to take a cut in salary in return for a non-cash benefit from their employer. As such, it can have knock on implications for other salary related elements of the individual's employment package. For example:

• contractual employer and employee pension contributions are usually linked to salary;
• defined benefit pensions are based on pensionable salary;
• life assurance cover is often set as a multiple of salary;
• PHI cover is normally salary related;
• overtime rates, sick pay and holiday pay are usually linked to salary;
• future salary rises tend to be based on current salary.

Given this, unless other elements of the employment package are reviewed as part of the introduction of a salary sacrifice facility, employees opting for salary sacrifice can be worse off overall.

To tackle this, many employers offering salary sacrifice facilities have changed employment contracts and pension scheme rules to base salary related elements of their employment package on a notional (pre-sacrifice) salary. This approach, which is particularly popular with the increasing number of employers who offer a flexible benefits package, creates a level playing field for all employees regardless of whether they choose to take up the salary sacrifice option.

How can salary sacrifice affect an individual's entitlement to State benefits?

The qualification criteria for State benefits vary widely, so the effect that a salary sacrifice arrangement can have on a person's entitlement to State benefits and tax credits depends on their personal circumstances and the particular State benefit(s) involved.

• Entitlement to State benefits such as Incapacity Benefit, Jobseeker's Allowance and the basic State Pension depend on the individual's National Insurance contribution record. In most cases, this means that entitlement will probably not be affected by a salary sacrifice arrangement - so long as the reduced earnings remain above the lower earnings limit.
• Entitlement to other State benefits, such as State Second Pension, Statutory Maternity Pay, Statutory Paternity Pay, Statutory Adoption Pay, Statutory Sick Pay, means tested benefits or tax credits, are earnings related. This means that agreeing to a pay cut under a salary sacrifice arrangement is likely to have an effect on the person's entitlement to these benefits. For example, State Second Pension entitlement will be affected if the earnings are reduced to below the lower earnings limit or to an amount that falls below the upper accrual point.

So the potential impact needs to be carefully considered before entering into any such arrangement.