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Under a salary exchange (also called salary sacrifice) arrangement, the employer and employee agree that the employee's salary will be reduced in exchange for the provision of an additional non cash benefit by the employer (for example childcare vouchers or contributions to a pension scheme). This can lead to favourable treatment as regards income tax and (of most relevance for pension contributions) national insurance contributions (NIC). The savings will be made both in employee and employer NIC. Some employers agree to share the NIC saving they are making with the employees by raising the level of their contributions, but this is not a requirement.
Although salary exchange is a way of structuring remuneration so as to reduce tax, HMRC seems not to object, and has even issued guidance on how to structure an effective salary exchange arrangement.
The introduction of auto enrolment will increase payroll costs for many employers who don't currently provide pensions for all their employees. Salary exchange provides a way of balancing this extra cost with an NIC saving.
Employees can "opt-out" of the pension scheme into which they have been auto-enrolled. This could pose problems because an effective salary exchange arrangement should lock in employees for a certain period (normally at least 12 months) unless an employee experiences a "lifestyle change", such as marriage, divorce or pregnancy.
Thankfully, HMRC has clarified that salary exchange arrangements can be used with auto-enrolment. Their guidance confirms that employees can leave a salary exchange arrangement for pension contributions at any time. On opting-out, employees may receive a refund of the salary they exchanged. Any refund will be subject to tax and national insurance contributions as if the salary had not been exchanged. This reflects the auto-enrolment position that an member who opts out in the time limits is treated as if he had not been auto-enrolled.
Employers cannot require workers to make any choice, or provide information, as a condition of being enrolled in the relevant pension scheme. This means they cannot, before being auto-enrolled, be required to confirm whether or not they agree to a salary exchange arrangement. However, employers could tell workers that they will automatically become part of a salary exchange arrangement unless they decide otherwise. Care must be taken to ensure that this is an effective variation of the existing employment contract.
The alternative would be to auto-enrol employees without salary exchange, but offer them the right to opt into the salary exchange arrangement. In practice this is less attractive as it is likely to reduce the take up of the salary exchange arrangement (and so reduce the potential NIC saving for the employer).
The Pensions Regulator has confirmed that employers must provide an alternative to salary exchange. Without an alternative there would be a barrier to entry, which is not permitted under auto-enrolment law. Salary exchange can be the default option, but employees must be able to choose to pay their contributions from their salary (and bear the higher NIC costs). So an employee who is automatically enrolled into a pension scheme by way of salary exchange will be able to accept that situation, opt out of scheme membership altogether, or choose to remain in the pension scheme but opt out of the salary exchange.
The Pensions Regulator has also recommended that employers should keep salary exchange and auto-enrolment separate in the employee communications.
For defined contribution schemes, the auto-enrolment regime will eventually require contributions of 8% of a jobholder's "qualifying earnings". The employer must contribute at least 3%, but it could also pay some or all of the remaining 5%. The jobholder is only required to make up the shortfall, if any. This fits in with salary exchange arrangements, where normally only the employer directly pays a contribution.
However, the Pensions Regulator has said that, with salary exchange, the minimum contributions are 8% of the post-exchange salary. In other words, there is a lower minimum contribution for salary exchange members. In practice this would make the salary exchange route unattractive. However employers can make contributions based on the notional pre-exchange salary rate.
HMRC will not confirm approval or otherwise of a salary exchange arrangement until after it is in place. Because the effectiveness of a salary exchange arrangement depends on the proper construction of the employment contract, it is essential to get the documentation right. Employers should always take legal advice before putting in place any salary exchange arrangements, but the extra complexity caused by the interaction with the new auto enrolment duties makes this even more important. We can review the existing employment contracts, and draft or review the employee communications to make sure the arrangements work.
For more information, please contact Michael Jones on +44 (0)20 7203 8917 or firstname.lastname@example.org