With employer's National Insurance contributions (NICs) now at 15% and tax bands frozen, salary sacrifice arrangements are an increasingly popular choice for employees and employers looking to reduce their costs. These arrangements involve employees "sacrificing" their right to a portion of their pre-tax salary or bonus in exchange for non-cash benefits such as pension contributions and cycle-to-work schemes. This note gives an overview of how a successful salary sacrifice arrangement is put in place and the traps to watch out for.
If you would like to learn more about salary sacrifice arrangements, please contact a member of the Travers Smith Incentives and Remuneration team. Our details can be found at the end of this briefing.
1. What are the advantages of salary sacrifice?
For employees
Employees can use salary sacrifice arrangements to give up pay that would be subject to tax and NICs and receive a benefit that is exempt from such charges. Although we talk about sacrificing "salary", these arrangements can also be used in respect of one-off payments such as bonuses.
For employers
Where the benefit provided under a salary sacrifice arrangement is free from tax and NICs, employers will save the 15% employer's NICs charge that would be due on a salary payment. Even if the benefit doesn't attract such relief, there might be savings for employers in being able to provide the non-cash benefit at a lower cost than the salary it would have paid.
2. Which benefits are most commonly used with salary sacrifice arrangements?
We most often see salary sacrifice arrangements used in conjunction with employer contributions to registered pension schemes. However, participation in a cycle-to-work scheme is also popular and sometimes employees are given the opportunity to sacrifice salary in exchange for additional days' holiday. Anti-avoidance rules (considered later) have reduced the tax effectiveness of salary sacrifice arrangements with other non-cash benefits.
Pension Contributions
If an employee pays into a registered pension scheme, their contribution generally benefits from tax relief, but there is no equivalent relief for NICs. In contrast, employer pension contributions are relieved from both tax and NICs.
Therefore, if employees give up a proportion of their salary before it becomes subject to tax and NICs, in return for an additional employer pension contribution equal to the salary that has been given up, this will benefit from NICs savings for both the employee and the employer.
It is important to note that there are annual limits on the contributions that can be made to a registered pension scheme and benefit from tax relief. Broadly, this is currently £60,000 per tax year and includes both employee and employer contributions1. Employees effectively have to pay income tax on any contributions that exceed this limit (although it is possible to "carry forward" any unused annual allowance from the previous three tax years to offset this). Moreover, the annual allowance of £60,000 reduces for those with income in a tax year over £200,000.
Since employee pension contributions benefit from marginal rate tax relief, the benefit of pensions salary sacrifice is purely in respect of NICs.
Cycle to Work Schemes
Many companies offer participation in the Government's "cycle to work scheme" through salary sacrifice arrangements. Under this scheme, provided certain conditions are met, employers can lend bicycles and associated safety equipment to employees free of tax and NICs.
3. What are the essentials for implementing a successful salary sacrifice arrangement?
For a salary sacrifice arrangement to be effective, the employee's right to receive cash remuneration must be contractually reduced. It is therefore essential that:
- the individual's employment contract (to reduce their salary) is amended before implementing the changes; and
- the revised contract entitles the employee to lower cash remuneration and a benefit.
In practice, this means that the employment contract must be varied in advance of the arrangement coming into force. Failure to do so will result in the employee receiving the lower salary, but being taxed according to their original, higher salary.
The variation of contract usually takes the form of a letter that the employee signs. The same approach is taken in relation to bonuses. The employee must give up their right to all or a proportion of their bonus before they become entitled to receive it for tax purposes. Where the bonus is discretionary, technically speaking there is no "sacrifice" as such (because the employee has no entitlement to receive the bonus) but the employee will sign an expression of wishes to receive a lower bonus and a (typically) pension contribution.
Care with the timing of an effective sacrifice especially needs to be taken where directors are entering into salary sacrifice arrangements, as they can be treated as receiving a payment of salary or bonus for tax purposes earlier than non-directors.
4. Points to be aware of
While salary sacrifice arrangements can offer considerable advantages, businesses planning to implement them need to be aware of some potential pitfalls.
Reversing the salary sacrifice arrangement
If an employee wants to withdraw from a salary sacrifice arrangement, forgo the employer pension contributions and re-instate their gross salary (or bonus) back to the original amount, then their employment contract must be varied again. It is typical to only allow employees to do this once a year, or if certain 'life-changing events' take place.
National Minimum Wage
Employers must ensure that an employee's post-sacrifice salary does not fall below the National Minimum Wage (as at 1 April 2025, this is £12.21 per hour for workers 21years and over, or £23,000 per year). Employers should have robust systems in place to monitor employees nearing this threshold and make informed decisions about who ought to be invited to participate in salary sacrifice arrangements.
The Optional Remuneration (OpRA) Rules
The OpRA Rules have removed the tax advantages of salary sacrifice arrangements for a number of benefits-in-kind. The effect of the OpRA rules is twofold; they remove the tax and NICs reliefs available in respect of some benefits and they also change the amount on which tax and NICs are charged. Fortunately, employer contributions to registered pension schemes and benefits provided under the cycle-to-work scheme are currently exempted from the OpRA rules.
Impact on other benefits and contractual provisions
Other employment-related benefits (such as pension contributions, death in service lump sums, annual bonus, future pay rises or share based awards) or certain contractual clauses such as "pay-in-lieu of notice" provisions, might be calculated by reference to an employee's gross annual salary. A reduction in gross annual salary because of a salary sacrifice arrangement will have an impact on these calculations and there is no automatic up-lift (unless expressly provided for in the employee's employment contract). Therefore, so that participants in a salary sacrifice scheme aren't at a disadvantage, it is possible (but not mandatory) to make such a change and state that for the purposes of these calculations the employer will use a "notional" or "shadow" salary which includes the pre-sacrificed amount.
Salary sacrifice arrangements can also impact on an individual's entitlement to statutory benefits such as statutory maternity, paternity and adoption pay. When applying for a mortgage or loan, providers may only take into account an individual's reduced salary (and ignore the corresponding employer pension contribution). It is good practice for employers to provide those looking to participate in a salary sacrifice arrangement with a broad outline of these effects and recommend that employees seek professional advice from a duly authorised financial advisor before making any decision.
Pensions and family leave
Legislation in respect of certain periods of paid family leave (specifically maternity, paternity and adoption leave) requires the continuation of employer pension contributions based on what the employee would have been paid but for their absence. By contrast, the employee only has to pay contributions based on the pay they actually receive during their period of leave (if any).
With a salary sacrifice arrangement, all pension contributions are employer contributions and so the obligation to pay them will be unaffected by the pay the employee actually receives during their period of leave. In theory, an employee may be able to increase their contribution rate before a period of leave and receive higher contributions than normal given the reduced pay they are receiving during that period. Or they may already be voluntarily making high contributions, including additional voluntary contributions. Salary sacrifice in these situations could result in payment of a disproportionately large benefit.
As a separate point, statutory maternity, paternity and adoption pay cannot be sacrificed: it is required by law to be paid.
In conclusion, salary sacrifice arrangements can offer financial benefits for both employees and employers, however, care is needed to ensure they are implemented and operated correctly.
Footnote
1. If the scheme is a defined benefit scheme rather than defined contribution, the value of the accrued benefit needs to be calculated
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
