Part one of this article looked at the potentially significant benefits which could accrue to employers and employees, by using tax-efficient salary sacrifice arrangements – particularly where employees were facing the higher marginal tax rates associated with the clawback of child benefit, or the loss of the tax-free personal allowance (broadly £50,000-£60,0000 and £100,000-£120,000 respectively).
In this concluding article, we shall look at the possible pitfalls – why salary sacrifice may not be appropriate for everybody – and the criteria which HM Revenue & Customs (HMRC) imposes in order for the sacrifice to be effective for tax purposes.
Pitfalls
1 – National minimum wage – Basically, cash wages after a salary sacrifice cannot be less than the national minimum wage (NMW), whatever the value of the additional benefits received. The adult rate has just increased to £6.50 per hour. It is the employer who is liable to ensure compliance with the NMW legislation.
2 – State pension/benefit entitlement – ‘Contributory’ state benefits require that the employee has paid enough in National Insurance contributions (NIC), (or at least earned at a minimum level for NIC purposes, broadly throughout the tax year), in order to secure entitlement.
Contributory benefits include:
- State Pension
- Jobseekers’ Allowance (JSA)
- Employment and Support Allowance (ESA)
Practically speaking, this means that an employee should ensure that he or she is still earning at least enough cash salary to ‘trip’ the lower earnings limit (about £5,800 this year). An employee needs to check that his or her regular wage/salary throughout the year is at least equivalent to the lower earnings limit: occasional bonuses or similar which make up the difference are no help.
3 – Statutory maternity pay (SMP) – Here again, there must be a qualifying period during which the employee earns at a rate (at least) equivalent to the lower earnings limit for the period. But even if the employee earns comfortably above the lower earnings limit, the enhanced rate of 90% of ‘average weekly earnings’ for the first six weeks of the SMP claim are effectively based on cash salary (strictly, earnings subject to Class 1 NICs) so initial entitlement may be reduced if salary has been sacrificed in return for non-cash benefits.
4 – Tax credits – Working tax credits and child tax credits entitlements may actually be improved by taking a lower salary for tax-favoured benefits, since the awards taper off as taxable incomes increase.
However, there is a particularly nasty twist for people who sacrifice salary for childcare vouchers, because in that case, you are potentially taking a pay cut to get vouchers towards something which is largely covered already by tax credits. The tax credits award will be substantially reduced because it basically ignores childcare costs covered by childcare vouchers.
Example: Childcare vouchers and tax credits
Let’s take Asif from last month’s example, but instead of a family income of roughly £70,000 he and his wife together earn £25,000, with two children in childcare costing £150 a week each.
Now, those same arrangements sacrificing £243 a month for childcare vouchers could result in his being almost £1,000 a year worse off, despite the same savings as before in income tax and NICs of almost £1,000. His tax credits childcare award will decrease by roughly £2,000 thanks to the reduced childcare costs he personally pays – see https://www.gov.uk/childcare-vouchers-better-off-calculator for a more detailed calculation.
5 – Other benefits – Such as employer pension contributions, bonuses or pay rises, or insurance policies for employees, are typically based on a percentage (or multiple) of gross salary. The employer may pay over less if the cash salary is reduced, depending on how the remuneration package is structured. There are similar implications for mortgage applications or ‘relevant earnings’ for employees looking to maximise their own private pension contributions.
6. - Reference/notional salary – One way to deal with this (and potentially the similar effect on SMP) is to agree a ‘reference salary’ which recognises the pre-sacrifice award, and which both employer and employee can agree to use as the basis for future pay rises, employer contributions, etc. HMRC confirms this does not invalidate salary sacrifice arrangements (see HMRC’s Employment Income manual at EIM42771).
7. – VAT on sacrificed salary – a European Court case (CJEU C-40/09) decreed that the provision of vouchers instead of ‘normal’ salary (for Astra Zeneca’s employees) was, in effect, a sale by the employer of vouchers in return for the forfeited salary, and should be subject to VAT.
So, the employer may now have to account for output VAT on the cost of benefits provided under salary sacrifice. Remember that the taxable value of a benefit-in-kind is normally the VAT-inclusive cost to the employer, even if the employer can reclaim the VAT.
While childcare vouchers are VAT-free in any event, HMRC says that any input VAT cost on providing such exempt supplies, such as the voucher scheme’s administrative costs, may be blocked. Furthermore, the employer may then have to deal with the VAT partial exemption regime. All in all, it makes you wish Astra Zeneca had stuck to reclaiming VAT on the cost of entertaining overseas businesses...
HMRC criteria for successful salary sacrifice
The legal construction of the revised contract must mean that the employee is no longer entitled to the full amount of the original salary, (or put another way, that the employee is now entitled only to the reduced cash amount).
It is not sufficient for the arrangement to be that the employee is merely asking the employer to convert some of his existing salary entitlement into non-cash form. Nor can the employee easily reinstate the pre-existing contractual terms: if the employee can effectively convert the new benefit (back) into money, then it is caught as earnings under what is now referred to as the ‘Heaton v Bell principle’ (Heaton v Bell [1969] 46 TC 211). But there are some benefits which are simply not chargeable to income tax even if they could be converted into money’s worth, such as childcare vouchers, or employer pension contributions (see EIM42755).
The contract must be varied to reduce any entitlement to cash salary/wages before any changes are implemented. For example, once an employee becomes entitled to receive a bonus in cash payment, it is too late to change his or her mind and ask for it to be paid into her pension instead. The date on which an employee is entitled to be paid can of course be after the date on which a bonus is discussed or agreed but care is needed to ensure that any sacrifice comfortably precedes entitlement – and particularly so for directors, for whom the rules are even more stringent (see EIM42260).
A further consideration is to make sure that the tax-favoured benefits are so eligible regardless of any salary sacrifice arrangements – for instance, childcare vouchers must be available broadly to all employees, and not just as part of individual salary sacrifice negotiations (EIM22015).
Conclusion
While there are some potentially valuable benefits for both employee and employer to establishing a tax-effective salary sacrifice scheme, they may not benefit all employees the same way – or at all.
Care is needed to ensure that the scheme works and provides the advantages as intended.
Practical Tip:
Whilst a salary sacrifice agreement basically needs to be binding in order to be effective, it is advisable for employees to be able to opt out of any arrangements on offer, particularly for lower-paid employees who could conceivably be worse off, despite the employer’s good intentions.
