HM Revenue & Customs has launched a consultation on limiting the range of benefits that have income tax or national insurance (NI) contributions advantages when provided as part of salary sacrifice or flexible benefit arrangements.
The closing date for comments is 19 October 2016. The consultation will affect salary sacrifice and flexible benefit schemes where cash remuneration can be exchanged for benefits in kind.
Benefits that will not be affected are:
• Employer pension contributions,
• Employer-provided pension advice,
• Employer-supported childcare and provision of workplace nurseries,
• Bicycles and cyclist’s safety equipment provided under the Cycle to Work scheme.
Payroll giving to registered charities will also not be affected, although the government is considering whether employee and employer NI contributions should be applied if offered through salary sacrifice. Sacrifice for intangible benefits, such as annual leave, will not be affected.
The intention is where a benefit in kind is provided through salary sacrifice, it will be chargeable to income tax and class 1A employer NI contributions (even if normally exempt) to the greater of:
• The amount sacrificed,
• A specified cash equivalent (if any).
Salary sacrifice can still be offered for benefits affected by the proposed change, but there will be no tax or NI contribution advantages. Affected benefits offered outside salary sacrifice, for example on top of salary, will retain their NI and tax treatment.
Any decision on this will be announced in the Autumn Statement, and any policy changes will be part of the Finance Bill 2017 and take effect from 6 April 2017.
Pension funding
Salary sacrifice will remain the most tax-efficient way for an employee to fund an approved pension scheme in most cases, and the employee has no personal tax or benefit-in-kind implications. The employer should benefit from full relief against corporation tax.
Employees
The principle reason for salary exchange is the saving made on NI contributions on exchanged salary or bonus. This is the alternative of employee contributions paid from an employee’s net pay, which will have already suffered employer and employee NI contributions. The contributions are:
• 12 per cent on band earnings between the primary threshold (£155 a week or £8,060 per annum) and the upper earnings limit (£827 a week or £43,004 per annum)
• 2 per cent on earnings over the upper earnings limit (£827 per week or £43,004 per annum)
Employers pay class 1 NI contributions of 13.8 per cent on earnings above the secondary threshold of £156 per week.
Salary sacrifice is made more attractive if the employer adds their NI savings to the pension contribution.
Table 1 demonstrates how the overall pension contribution can be boosted using salary exchange, where the employer also rebates their NI saving in full. In this case the employer NI contribution saving of £690 is added to the pension contribution, giving the employee a combined net income and pension contribution value of £39,256. This compares to a net income of £36,466 with no pension contribution.
Tax reclaim benefits
A salary exchange arrangement also eliminates any delay in receiving higher rate tax relief as personal tax is not relevant. This contrasts with personal employee contributions, where higher rate tax relief is reclaimed via self-assessment and typically adjusted through the tax code.
Tax-tipping points
In addition to the NI savings, salary or bonus exchange becomes even more valuable at various tax-tipping points. The more obvious points are to use salary exchange to reduce taxable earnings when they cross from one tax band into the next, especially at the higher rate tax (£43,000 and above), additional rate tax (£150,000 and above) and the loss of personal allowance (£100,000 and above) thresholds. It is important to take into consideration other taxable income in salary or bonus sacrifice calculations.
Bonus sacrifice is also useful where investment income or the taking ofprofits or gains would draw an employee into a higher or additional rate band.
A reduction in bonus and taxable income might limit a capital gains tax rate to 10 per cent (or 18 per cent for gains on certain residential property) rather than 20 per cent (or 28 per cent) or prevent top-sliced profits from an onshore investment bond encashment being subject to higher rate tax.
Disadvantages of salary sacrifice
Salary is not just reduced for a scheme definition of pensionable salary, but may also for other purposes such as:
• Entitlement to state benefits and state pensions. This may include statutory maternity pay, statutory redundancy pay, statutory sick pay, working tax and child credit, and additional state pension.
• Mortgage or other loan approvals,
• Death in service benefits,
• Maximum cover on income protection policies,
• Repayments of student loans.
These issues may not be as relevant for bonus exchange because bonuses are usually otherwise omitted for many of the above purposes. In addition, some employers use a reference salary, which is the amount of the original salary before the exchange.
Employers will continue to use this as the basis for calculating future pay reviews, employer pension contributions and any company benefits that may become due under life assurance or income protection schemes.
Salary exchange may also not be tax-efficient where the employee’s pension funds are close to, or exceed, the lifetime allowance, especially if the employee is close to their retirement date.
Here, the financial adviser needs to consider the value of the employer contribution plus any growth/accrual with the excess tax paid on exit (25 per cent plus income tax rate or 55 per cent on lump sums).
Setting up salary exchange
Salary and bonus exchange require the employer’s agreement. The salary reduction will normally be noted by a change in the employment contract. The principle must be agreed and documented before the salary or bonus is treated as received for tax purposes.
HMRC’s manual on salary sacrifice states that the new arrangement must result in a change to the employee’s contract of employment. It may be worth considering evidencing this by an exchange of letters, so these can be produced to HMRC should the exchange be challenged.
Salary sacrifice and the spreading of employer contribution tax relief
Employer pension contributions are generally an allowable expense in calculating profits. Such contributions reduce tax for the accounting period in which the pension contribution is paid, and so provide tax relief for the employer.
Large increases in employer contributions from one accounting period to the next can mean the pension contribution is not wholly allowable in the accounting period in which it is made. Instead part of the contribution is spread forward over future accounting periods. This could be triggered if lots of employees set up salary sacrifice in one year or have significant salary increases and sacrifice as a percentage.
Where the adjusted employer contributions have increased by at least 210 per cent (for example, they have more than doubled) from one accounting period to the next, and this increase is at least £500,000 then tax relief may need to be spread.
If no employer contributions were paid in the previous accounting period, there will be no spreading of tax relief on contributions paid in the current accounting period.
Danny Cox is a chartered financial planner at Hargreaves Lansdown
