Reshma Johar responds to a Reader’s forum question for Taxation magazine:
What is the true effect of a restructuring of pension contributions?
My employer operates a defined contribution pension scheme. At present, let us say that the employer pays £100 into the scheme for me each month and pays me a salary of £1,000 from which I contribute another £100 to the scheme. The employer has recently written to suggest that employees’ National Insurance contributions could be saved by restructuring the payments. The proposal is that employer will increase its contribution to £200 and simply pay me a reduced salary of £900, but I make no pension contributions. Am I receiving a fair share of the National Insurance saving from this suggestion? Also, will the apparent salary reduction have any other adverse effects? Query 19,198 — Employee
Consider the side-effects of a reduced salary
As the judge said in Cape Brandy Syndicate v CIR 12 TC 358, there is no equity about a tax. However, this proposal is not really about fairness, but about whether Employee is happy to accept it and whether it works. On the figures quoted, the employer will pay £13.80 and the employee will pay £12 in National Insurance; the pension fund receives £200; and the employee pays income tax on £900 a month. National Insurance is not payable by either party; the pension fund receives the same total contributions and the employee pays the same income tax. So there is a saving of £25.80 shared between the parties. That seems eminently fair — it would be possible for the employer to suggest an arrangement under which the employee would be no worse off but the whole benefit would accrue to the employer.
The arrangement should work because payments to registered pension schemes are exempt from the rules that were introduced to counter salary sacrifice schemes from April 2017. HMRC’s booklet on expenses and benefits (Notice 480) has a good explanation of the taxation of ‘optional remuneration arrangements’ in its final appendix. However, the replacement of salary and employee contributions with a lower salary and non-contributory pension scheme would have to be reflected in the employee’s contract — if this is not done, the extra payment by the employer to the pension fund will be regarded as salary that has been paid to a third party, and it will still be subject to National Insurance.
There should be no tax-related downside because the employee is still paying National Insurance and therefore still accruing benefits. Because the state pension is no longer earnings-related, a cut in the contributions will not affect the eventual entitlement as long as there is still a full credit for 35 qualifying years. In a final salary scheme, a cut in gross pay can have serious consequences, but that is not relevant if the pension will be based only on the accumulated pot of money. There are other possible effects of a cut in basic salary — it could affect bonuses, overtime rates and maternity pay. It is worth asking whether there are any other matters that are based on that gross salary figure.
It is also necessary to consider the auto-enrolment rules — the normal situation now is that both the employee and the employer make contributions. However, HMRC’s guidance on auto-enrolment recognises the possibility of salary sacrifice — it calls it a SMART scheme, so clearly does not disapprove of it. If the current pension arrangements are within auto-enrolment it may be necessary to opt out as part of the change of contract. — Castlegate.
The pension payment is a tax-free benefit.
Under current arrangements, the employer makes a contribution into the pension of £100, which is a tax-free benefit for Employee. The £100 contribution Employee makes is from taxed income and is treated as if it has been made net of 20% basic rate tax. As such, the government tops up the pension fund with £25, representing £100 grossed up by 20%. Further, if Employee is a higher rate or additional rate taxpayer their income tax bands are extended by the gross personal contribution made (in other words, £125).
As with the current arrangement, any contribution made by the employer will be a tax-free benefit. Because Employee’s contribution under salary sacrifice would be made from gross rather than taxed income (net), it will be made before the deduction of income tax and National Insurance contributions. For the employer, the amount sacrificed by will create an employer National Insurance saving. However, the government will not top up the pension fund with 20% because contributions are being made gross (rather than net) nor will there be any extensions of the income tax bands. The employer has a choice on whether the National Insurance saving (13.8%) is kept by the company or partly or fully added to the pension fund. Under this arrangement, a maximum of £213.80 a month would go into the fund. Because this arrangement results in less going in than the current arrangement, the employer may wish to top up their contribution to cover the shortfall (£11.20)
Although the amount suggested to be sacrificed is relatively low, Employee should also consider the implications of receiving a lower salary (annual gross earnings reduced by £1,200). This could affect borrowing ability because gross salary is often used to determine this. Further, entitlement to some state benefits may also be affected. It may reduce overall income to below £50,000. This may entitle the individual to child benefit, which previously may have been reduced or withdrawn altogether.
Employee should review their overall tax position against the above and discuss any concerns with the employer before making any changes to the current arrangement.