One of the most important developments affecting the owner managed business in their capacity as an employer over the next two to three years will be the implementation of auto enrolment. The smaller business sector with less than 50 employees start the process from 1 June 2015 onwards, with phased staging dates over the subsequent two year period. Employers will seek to minimise costs and maximize tax reliefs. Employees, whilst appreciating the need to provide for a pension in retirement, will also seek to do this in a tax and cost efficient manner.
A salary sacrifice arrangement will be an attractive option to consider in achieving both goals, particularly from October 2018 when the minimum contributions payable by the employer and employee rise to 3% and 5% respectively. Whilst the operation of a salary sacrifice arrangement is separate to the automatic enrolment provisions, an employer may run the two processes in parallel when complying with their employer duties.
What is salary sacrifice?
Salary sacrifice arrangements involve a contractual right to cash pay being reduced. For that to happen two conditions have to be met:
- the potential future remuneration must be given up, and
- the true construction of the revised
contractual arrangements between employer and employee must be that the employee is entitled to lower cash remuneration and a benefit instead.
Under auto enrolment salary sacrifice arrangements can therefore be used to meet the full 8% contribution provided that active membership of the pension scheme can be achieved without the jobholder having to consent to the salary sacrifice arrangement before they are made an active member.
What is crucial is that salary sacrifice cannot be the only payment method allowed for membership of the pension scheme.
Why is the arrangement advantageous?
Both the employer and employee save money because there are reductions in the individual’s gross pay which is liable to employer and employee National Insurance contributions (NIC) in exchange for the pension contribution by the employer which is tax and NIC free.
Therefore there are savings in:
- the employee’s NIC payable on the salary sacrificed of up to 12%
- the employer’s NIC payable on the salary sacrificed of 13.8%.
There is no tax saving as the tax saved by giving up the salary is cancelled out by the tax relief top up from HMRC that would have been available on the employee’s net contribution.
A basic rate employee has a salary of £30,000 (no other remuneration) and surrenders the right to £1,500 (5%) salary in exchange for the employer making a pension contribution of the same amount. If there was no such arrangement, the employee choosing to remain in auto enrolment would have net pay using 2014/15 rates of £22,155 after £1,200 pension contributions are deducted from net pay. This would be topped up by HMRC with tax relief of £300 so that £1,500 goes into the pension scheme.
By participating in a salary sacrifice arrangement the new salary is £28,500 but the net pay will be £22,335 due to the NIC saving of £180 (£1,500 x 12%) and the employer puts £1,500 into the scheme. In addition the employer saves 13.8% on the reduced salary of £207.
A salary sacrifice arrangement cannot reduce an employee’s cash earnings below the National Minimum Wage.
What do employees need to consider?
When entering a salary sacrifice arrangement to replace part of cash pay with the tax/NIC free benefit, it is essential that employees understand what the sacrifice will mean in practical terms and consider carefully the effect, or potential effect, that a reduction in their pay may have. In particular, entitlement to state benefits such as Statutory Maternity Pay (SMP) is affected.
If you have an interest in salary sacrifice, please get in touch so that we can discuss matters further.