This guide is based on UK law. It was last updated in July 2009.
Salary sacrifice arrangements have become increasingly common in recent years. They offer clear advantages for employers and some benefit for employees too. But care needs to be taken in setting them up and safeguards should be put in place.
What is salary sacrifice?
As the name suggests it involves employees giving up part of their salary, but in return for another benefit.
In a typical case where the employees are active members of a defined benefit occupational pension scheme and paying basic contributions of 5% of pay to the scheme then salary sacrifice could involve the following: The employer might no longer require the employees to pay pension contributions. Instead, the employer would pay these contributions for them. On a salary of £20,000 a year this would save the employee £1,000. However, the employee's actual salary would then be reduced by the same amount, i.e. from £20,000 to £19,000.
Benefit of salary sacrifice for employers
The benefit is in the saving the employer achieves in National Insurance Contributions (NICs). The employer pays NICs on the employees' salaries but not on pension contributions. The higher the salary, the more the employer has to pay in NICs. Reducing the employees' salaries would therefore allow the employer to pay less in NICs. Collectively, across a large workforce, an employer can achieve a substantial saving in NICs. Substantial increases in the band of earnings on which NICs are payable, which are taking place between 2008 and 2010, could increase the attractiveness of salary sacrifice.
Benefit of salary sacrifice for employees
The saving in pension contributions and the reduction in salary should cancel each other out. The advantage beyond that is that the employees should also pay less in NICs. Like the employer, the employees pay NICs on salary, so the lower their salaries the lower their NICs will be. This should produce an overall saving for employees.
Will this affect employees' pensions?
It should not do so. An employee's actual salary might be reduced from £20,000 to £19,000. However, the employee's pension will still be based on the previous higher salary – known as a "reference" or "notional" salary. The definition of pensionable salary in the pension scheme's rules will usually be amended to allow this.
Will this affect other benefits?
It could do. If salary sacrifice pushes an employee's salary below the Lower Earnings Limit for the purpose of paying NICs then certain state benefits could be affected. These include the basic state pension, statutory sick pay and statutory maternity pay.
Reductions in salary below the Upper Earnings Limit could also reduce employees' entitlements to the state second pension. There might also be an impact on other employment benefits and salary multiples for mortgage purposes, although in practice employers should be able to remove or limit any impact.
Salary sacrifice could also affect entitlement to working tax credit or child tax credit, and it must not take pay below National Minimum Wage rates. Salary sacrifice is therefore not suitable for all employees, and employers should bear this in mind when deciding whom to include and exclude from salary sacrifice.
Do you need the employees' agreement?
Strictly speaking, yes. Employees will probably have a contractual entitlement to their current salary. If it is reduced as part of salary sacrifice then this amounts to a change in their contractual terms. If this is done without the employees' explicit agreement then this could amount to a breach of contract.
However, employees are unlikely to complain if they gain overall from salary sacrifice. In practice, employers often automatically include employees in salary sacrifice, while at the same time allowing them to opt out if they wish. Most importantly employers should ensure that employees are kept fully informed about all aspects of the salary sacrifice and its impact on employees both before and after implementation.
Do pension scheme trustees have to agree?
Some amendments may have to be made to the pension scheme's rules in order to implement a salary sacrifice, and so the trustees' agreement may be necessary. However, the trustees should be able to agree on the basis that employees' benefits from the scheme are not affected by salary sacrifice.
Isn't this all a bit of a tax dodge?
Salary sacrifice is not tax avoidance; it is tax mitigation. The objective is of course to reduce employer and employee NICs, but this should be seen against the backdrop of occupational pension schemes in crisis and employers doing what they can to maintain these schemes.
What does HMRC have to say about that?
Quite a lot, and it's all fairly helpful and positive although HMRC is the main loser from salary sacrifice because of the reduction in NICs.
HMRC permits salary sacrifice. The HMRC guidance includes an eight-page guide and a shorter Q&A on how to make salary sacrifice effective.
HMRC insists that salary should be given up completely before it is treated as received for tax and NIC purposes. Its guidance also explains in some detail what impact salary sacrifice might have on other benefits.
Salary sacrifice arrangements do not have to be approved by or notified to HMRC but it is open to employers to consult HMRC on the correct tax treatment of the arrangements. However, the fact that HMRC gives this guidance is no guarantee that it might not clamp down on salary sacrifice at a later date (although there is currently nothing to suggest that it will).
What about defined contribution and personal pension schemes?
Salary sacrifice can be done in largely the same way as with defined benefit schemes. The employees' salary will be reduced, their pension contributions will be reduced by the same amount and the employer will instead contribute this amount to the defined contribution/personal pension scheme.
Can bonus and termination payments be 'sacrificed'?
Yes, bonus and termination payments can be sacrificed in return for a pension contribution from the employer and/or increased pension benefits. Special care must be taken to ensure that these payments are given up before any entitlement to them arises and with the personal tax consequences for the individual employee.
Although the Government's overall tax revenue could well go down in the current economic climate, for now it appears unlikely that salary sacrifice will be discouraged – although potentially salary sacrifice might reduce the Government's revenue from NICs by up to £1 billion a year. If anything, on current trends salary sacrifice is probably set to increase in popularity as more employers appreciate the NIC savings it can generate, especially as NICs become payable over a wider band of earnings.
However, any salary sacrifice arrangement must be planned and implemented carefully with full communication, and employers should seek detailed financial and legal advice so that they and their employees are fully aware of the benefits and possible pitfalls in advance.