Although as a general rule an employee is taxed on non-cash remuneration, such as benefits in kind, the tax legislation contains a number of exemptions that make it possible to provide certain benefits free of tax and National Insurance contributions. However, a benefit is only worthwhile if the employee actually wants to receive it and not all employees will value the same non-cash benefits.
The challenge is to take advantage of the tax exemptions on offer whilst offering a degree of individual choice without increasing the overall cost to the employee.
Luckily salary sacrifice arrangements offer a solution to this dilemma.
Nature of Salary Sacrifice
Under a salary sacrifice arrangement an employee gives up some of his or her cash salary in exchange for a non-cash benefit. Where the benefit in kind is exempt from tax and National Insurance, the employee is better off financially than if he or she had continued to take the salary and then paid for the `benefit’ from his or her net pay. The employer also saves the National Insurance that would have been payable on the cash salary foregone.
Childcare vouchers, which are exempt up to a value of £55 per week, are typically provided by means of such an arrangement. By swapping £2,860 of cash salary for childcare vouchers of £55 per week, a basic rate taxpayer saves tax of £572 and (at the main rate of 11%), National Insurance of £314.60. A higher rate taxpayer saves tax of £1,144 and National Insurance (at the additional rate of 1%) of £28.60. The employer also saves National Insurance of £366.08 (£2,860 @ 12.8%).
There are still benefits to be had if the employee swaps salary for a non-exempt benefit in kind. This is because most benefits in kind are subject to Class 1A National Insurance contributions rather than Class 1. As the Class 1A charge is an employer-only charge, moving the liability from Class 1 to Class 1A means the employee saves National Insurance. If the employee pays National Insurance at the main rate of 11%, this can be worthwhile. However, in this situation there are no savings available to the employer.
Avoiding the Pitfalls
The tax savings will only materialise if the taxman regards the arrangement as `effective’. This means that the employee must not be able to revert to the higher salary at will and the employee’s contractual arrangements must reflect the revised position. If this is not the case, the taxman will ignore the arrangement and tax the employee as if he had continued to receive the higher salary.
Care must also be taken when dealing with employees on low incomes. If cash salary drops below the lower earnings limit for National Insurance purposes (currently £95 per week), entitlement to statutory payments and the basic state pension may be jeopardised.
It is also worth noting that where non-cash benefits are provided, the employer must maintain these throughout an employee’s maternity leave.
Time Running Out
Although HMRC has hitherto accepted salary sacrifice arrangements as legitimate tax planning, there are indications that the tide may turn. After plans to remove tax relief for childcare vouchers where provided under salary sacrifice arrangements were dropped, the Chancellor instead turned his attention to free and subsidised meals. From 6 April 2011, the tax exemption in respect of free and subsidised meals will be lost where these are provided under a salary sacrifice arrangement.