Salary sacrifice and flex benefits

Updated February 2009

What is salary sacrifice?
Salary sacrifice (sometimes called salary exchange) is the exchange of salary for an alternative and more tax efficient benefit. 'Flex benefits' packages are often built around salary sacrifice.

How and why does it work?
Salary is subject to income tax and national insurance. By exchanging salary for a non-taxable benefit, such as childcare vouchers, the amount of tax and national insurance the employee has to pay is reduced but the overall value of their employment package remains the same. At the same time, the employer makes a 12.8% national insurance saving. Salary sacrifice can also be used to increase the national insurance efficiency of pension costs or to support the cost to employers of 'bike to work' schemes.

Example: Jack earns £35,000. He sacrifices £2,916 a year in return for childcare vouchers of the same value. The childcare vouchers are tax free so Jack saves 20% income tax and 11% national insurance on £2,916. His overall saving is £903.96 so the net value of his employment package has increased by that amount. His employer saves £373 in employer’s national insurance.

What effect has the Pre-Budget Report had on salary sacrifice?
Subject to a lower earnings limit, the current position is that on earnings up to £40,040 employees pay national insurance at a rate of 11%. Above that, employees pay national insurance at 1%. With effect from 6 April 2009, the 11% rate band will be extended to £44,000 increasing the national insurance burden on employees. With effect from 6 April 2011, national insurance will increase generally by 0.5%. Salary sacrifice relieves some of that national insurance burden, so it looks increasingly attractive.

How do you implement salary sacrifice?
Broadly, there are two ways of achieving an effective salary exchange: an 'opt-in' and an 'opt-out' approach.

The 'opt-in' approach requires each employee who wishes to take up salary sacrifice to enter into a written variation to their employment contract. Whilst this has the benefit of complete legal certainty, the 'opt-in' approach tends to be administratively burdensome.

For those reasons, a lot of employers are choosing the 'opt-out' approach i.e. where employees automatically enter into salary exchange from a specified date unless they inform their employer otherwise.

For the 'opt-out' approach to be effective from HMRC’s perspective, employees must be fully informed of the proposals, be given a specific date by which the 'opt-out' must be made and must continue working after the opt-out date and after the first pay-date following implementation without lodging a protest.

How does salary sacrifice affect Statutory Maternity Pay?
Statutory Maternity Pay ('SMP') is based, for six weeks at least, on gross salary. Salary sacrifice reduces gross salary and, therefore, reduces SMP.

How do the recent changes to maternity legislation affect salary sacrifice?
The reason the new legislation impacts on salary sacrifice is that salary sacrifice is all about swapping salary for benefits and the new maternity regulations have an impact on benefit provision.

The new regulations state that, whereas employers used to have to provide contractual benefits for the first 26 weeks of maternity leave, they must now provide those benefits for the entire period an employee is on maternity leave (potentially 52 weeks). An employee’s entitlement to salary or wages (in contrast to benefits) ceases during maternity leave and is replaced by SMP (the cost of which is subsidised by the Government).

The overall effect is that if an employee swaps salary for benefits under salary sacrifice and then goes on maternity leave, the employer's costs during maternity leave are increased because of the higher cost of continuing an employee's benefits during their absence.

Does the new legislation on benefits include pension?
Employer pension contributions have to be continued during paid maternity leave (i.e. 39 weeks). There is some debate as to whether they also have to be continued during the last 13 week unpaid maternity leave period.

In practice, most employers are following HMRC and BERR's Guidance in this area and are stopping employer pension contributions during the last 13 weeks of unpaid maternity leave. There is a small risk that this practice may be challenged as discriminatory on the grounds of sex.

What can be done to mitigate the impact of the new legislation?
The increased costs of maternity provision arising out of salary sacrifice needs to be seen in the context of the benefits of salary sacrifice as whole. That is particularly the case if the salary sacrifice is part of a much wider 'flex benefits' arrangement.

Specifically though, employers should consider imposing limits on the amount of salary that can be sacrificed under any salary sacrifice arrangement and limiting the 'window' for swapping salary for benefits. Those measures should reduce the likelihood of exploitation of the new legislation.

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at March 2009. Specific advice should be sought for specific cases; we cannot be held responsible for any action (or decision not to take action) made in reliance upon the content of this publication.