Salary sacrifice schemes

A salary sacrifice occurs when the employee agrees to accept a lower contractual salary, usually in return for receiving an additional non-cash benefit of approximately equivalent value. Popular salary sacrifice arrangements include enhanced employer pension contributions, childcare, and bicycles under the cycle to work scheme. Such arrangements have been around for many years, but are still often misunderstood.

It is important to appreciate at the outset that a salary sacrifice is effectively a contractual pay cut and entails the employee giving up the right to receive future salary, rather than simply accepting a temporary deduction from an existing salary. It is therefore a reduction in pay rather than a deduction from pay. For tax and National Insurance contributions (NICs) purposes, the employee is not ‘paying’ anything, so the sacrifice does not reduce the taxable amount (the P11D value) of benefits which have been provided in place of the salary foregone.

The incentive for the employee to agree to a salary sacrifice is that the new, lower rate of salary will be subject to lower deductions in respect of PAYE and Class 1 National Insurance contributions. Depending upon which benefit-in-kind is then substituted, the employee may still have to pay income tax on the value (as most benefits will be taxable and must be reported on form P11D) but they will still be better off overall because there are no employees’ NICs on benefits-in-kind. The recent reductions in employees’ NICs have eroded this saving from 12% to 8%, but it still represents a worthwhile exchange.

In general, this is not necessarily so for the employer because what is gained in Class 1 NICs on the reduced salary may be offset by the equivalent Class 1A NICs charged on the benefit-in-kind.

However, crucially there are some benefits (principally pension contributions) which do not give rise to either an income tax or Class 1A charge and which therefore present an opportunity for both the employer and the employee to gain on the deal.

There may be other valuable tax implications. Reducing the employee’s taxable income by substituting non-taxable pension contributions will be especially effective for higher rate taxpayers, and even more so for those with income between £100k and £125.4k who would otherwise lose their personal allowance. The higher income child benefit charge (HICBC) is also based on ‘adjusted net income’ which will be reduced by a salary sacrifice.

Practical considerations

Before committing to a salary sacrifice, there are considerations other than just the possible tax and NICs savings to take into account. Lower paid and part-time workers should be particularly mindful that (in some cases) the reduction in NICs could be detrimental to their entitlement to State Retirement Pension and other state benefits. If the salary sacrifice takes them below the Lower Earnings Limit for NICs, whilst there will be no National Insurance to pay, the consequence could be that the tax year would not be a qualifying year for benefits and pensions purposes. Note that as long as the earnings remain at least equal to the lower earnings limit (£123 per week in 2024–25), although no NICs are physically payable, the employee is treated as having paid NICs so a qualifying year is still achievable.

Employers should also be aware that any salary sacrifice is not permitted to reduce an employee’s pay to a level below the National Minimum Wage. Benefits-in-kind (other than accommodation and then only to a limited extent) do not count towards the National Minimum Wage. In this context, it makes no difference that the employee may have consented to, or even requested, the salary sacrifice – it must not be allowed to reduce pay below the National Living Wage/National Minimum Wage in any circumstances.

Anything which is dependent upon the employee’s gross pay will be affected by a salary sacrifice. For example, average pay for the purposes of Statutory Maternity Pay and other statutory payments (APP, ShPP, SPBP) will be reduced.

Mortgage lenders will normally only take into account the cash salary, so mortgage applications could be affected.

Other pay rates could also be affected by a salary sacrifice. It follows that if the standard pay rate is reduced, then anything which is calculated by reference to that rate will also be reduced, for example future pay increases and enhanced overtime rates. To avoid this problem, it may be sensible to make contractual provision for certain calculations to continue to be based on the original pay rate as it was before the sacrifice – often referred to as ‘reference pay’ or ‘notional pay’.

Implementation

In order to be effective for tax and NIC purposes, it is important to ensure that the salary is formerly waived before the individual is entitled to the payment, i.e. before they are due to be paid. Provided the agreement is in place before the entitlement to be paid arises, no income tax or NICs are due on the amount given up. This principle applies equally to one-off sacrifices in respect of bonuses – if a bonus is waived on or after its due date then tax and NICs will still be payable, even if the bonus is not paid over.

If an employee (or director) subsequently gives back part of their salary to the employer after they have been paid, tax and NICs are still due and cannot be reclaimed.

HMRC agree (  EIM42771 ) that the use of the use of reference or notional salary does not invalidate the salary sacrifice.

Optional remuneration arrangements (OpRA)

Because of the obvious potential savings, salary sacrifice schemes were becoming very popular and began to be abused (in HMRC’s view), largely in cases where alleged travel and subsistence expenses were being combined with salary sacrifice. Concerned over the potential fall in Government revenue, the result was that  Finance Act 2017  introduced legislation to remove the income tax and employer’s NICs advantages from most salary sacrifice (described in the legislation as ‘optional remuneration arrangements’) schemes.

The effect of OpRA is that (with certain exceptions) the taxable value of benefits provided under the arrangement is adjusted to whichever is the higher of either the normal taxable benefit or the ‘amount foregone’. The ‘amount foregone’ in relation to an optional remuneration arrangement, means the amount of earnings the employee has either sacrificed (Type A) or could have chosen to receive (Type B).

Fortunately, there are some exceptions to the OpRA rules, and pension contributions remain unaffected, as is employer-provided childcare and the cycle to work scheme. Ultra-low emission cars (those with CO ₂ emissions of no more than 75 grams per kilometre) are also excepted from OpRA.

Example (pension contributions)

Depending upon the pension arrangements, the position can be slightly complicated by the availability of tax relief in the pension fund itself, but as a simple example, if we look at the position of an employee with annual taxable and NICable income of £36,000 (after applying the tax/NICs thresholds) and making contributions of 5% from their net pay, rather than through a salary sacrifice, this can be shown as:

Employee	Employer	Pension fund
£3,000 monthly gross pay	£3,000 employee’s salary
£600 basic rate tax
£240 employee’s NICs	£414 employer’s NICs
£2,160 net pay		£150 employee’s contribution
£150 pension contribution		£37.50 tax relief in the fund
£2,010 take home pay	£3,414 total employer’s cost	£187.50 total receipts

 

By introducing a 5% salary sacrifice and thus keeping the pension contribution constant but simply changing it to an employer contribution, the position is then:

Employee	Employer	Pension fund
£2,850 monthly gross pay	£2,850 employee’s salary
£570 basic rate tax
	£150 pension contribution	£150 employer’s contribution
£228 employee’s NICs	£393.30 employer’s NICs	(no tax relief in the fund)
£2,052 take home pay	£3,393.30 total employer’s cost	£150 total in the fund

 

So the employee receives an extra £42 in take-home pay, whilst the employer has saved £20.70 – and though the pension fund has lost out by £37.50, overall the employee is still £4.50 better off. But with a little arithmetic and a sharp pencil, we can adjust the figures to ensure the employee’s pension fund receipts remain constant. By increasing the salary sacrifice to £187.50 (6.25%) we get:

Employee	Employer	Pension fund
£2,812.50 monthly gross pay	£2,812.50 employee’s salary
£562.50 basic rate tax
	£187.50 pension contribution	£187.50 employer’s contribution
£225 employee’s NICs	£388.12 employer’s NICs	(no tax relief in the fund)
£2,025 take home pay	£3,388.12 total employer’s cost	£187.50 total in the fund

 

So now we are in a position where the employee takes home an additional £15 in pay, the employer’s costs have reduced by roughly £25 and the pension fund receives exactly the same amount as when we started.

A generous employer may choose to give up part or all of the NICs savings and increase the pension contribution even further. With a little planning, this can be an arrangement in which everybody wins.