Saving money in the workplace without having to make redundancies is a constant challenge for company bosses. But Melanie Bien claims there are ways of cutting costs and keeping employees happy.

Although the word 'sacrifice' suggests something bad rather than beneficial, particularly when mentioned in the same breath as 'salary', it can be a way of giving more than you take away.

Salary sacrifice occurs when an employee gives up the right to receive part of the cash due under his or her contract of employment. In return, the employer draws up an agreement whereby it promises to provide the employee with some form of non-cash benefit instead. This usually takes the form of an additional pension contribution, but not always.

Stephen Herring, Tax Partner at BDO Stoy Hayward, believes salary sacrifice is the way forward for employers seeking to cut their tax bill. "Introducing a well-structured salary-sacrifice scheme really is no sacrifice at all," he says. "It allows employers to make significant savings on tax, which can be passed on to employees - properly implemented it's a perfect 'win-win' situation."

Salary sacrifice has become increasingly popular since the rise in National Insurance Contributions (NICs) for employers as well as employees in April 2003. The one per cent rise in contributions means employers now pay 12.8 per cent in NICs on all earnings paid to an employee above £91 a week for 2004/05. But with a salary-sacrifice scheme employers can cut back on their NICs, without being accused of tax evasion, while employees also benefit.

By utilising quirks in NIC rules, an employer can increase its employees' pension contributions without any increase in net outlay, for example. The employee gives up some salary or a bonus before it is paid to them, and receives instead an extra employer contribution to his or her pension. This agreement cannot be made after the pay rise or bonus has been awarded, however, and must be put in writing.

The employees benefit because the extra contributions from the employer counts towards the calculation of their tax-free lump sum at retirement. They also benefit from the tax relief that pensions attract: a higher-rate taxpayer receiving a pay increase of £600 would actually get £1,000 if it is accepted as a pension contribution instead.

The employer benefits by saving money on its National Insurance bill because any pension contributions made to an employee's scheme are free of NIC, unlike salary and bonuses, which attract both employer and employee NICs. So if a company gives an employee a pay rise, it is also liable for extra NICs, but if it increases its contribution to the employee's pension, the NI bill does not increase.

Figures from independent financial adviser Bestinvest illustrate how both employees and employers benefit if the former takes a smaller pay rise or bonus and the remaining cash goes into the workers' pensions. A £10,000 bonus or increase to salary would result in an NIC bill for the employer of £1,280, resulting in a final bill for the employer of £11,280. But if the employee forfeits all the salary or bonus, the company saves 12.8 per cent in NICs by paying only the £10,000 into the employee's pension. And if the employer is feeling generous it can pass some, or all, of this saving onto the employee as a further pension contribution.

There are some restrictions to bear in mind, such as the fact that salary sacrifice should not reduce the employee's cash pay below the National Minimum Wage. This is £4.50 per hour for workers aged 22 years and above and £3.80 per hour for workers aged between 18 and 21. Salary sacrifice could also affect an employee's entitlement to state benefits and tax credits, so companies should ensure that employees are aware of the possible effects before they go ahead with a change in their employment contract.

And once the employee has agreed to salary sacrifice, this decision cannot be reversed.

The non-cash benefit under a salary-sacrifice scheme does not have to be an extra employer pension contribution, but it may suit all employees who are approaching retirement and who wish to give their pension a boost, or those who were planning on increasing their pension contributions anyway.

Alternatives under salary sacrifice that may tempt employees include childcare vouchers, the provision of a nursery place, a home computer, a mobile phone or private medical insurance. Some of these options may better suit younger employees who would rather have something useful to them now.

Childcare vouchers are ideal for those with young children who are currently paying for childcare, for example, as this tends to be expensive and the cost will be coming out of their net salary. Under salary sacrifice, the employee stops paying for their childcare directly and instead foregoes a set amount from their gross salary. The employer provides vouchers to this amount, thus saving on NICs.

Home computers and mobile phones are not considered to be a taxable benefit as long as the employer retains ownership of them, rather than the employee, and the total value does not exceed £2,500. This can be cost-effective as an employee receiving a £2,500 computer package over three years, for example, would see their net pay reduce by as little as £10 a week. And at the end of the three years, ownership of the computer can be transferred for a nominal amount to the employee without any tax consequences.

Private medical insurance can also be offered to employees under a salary-sacrifice arrangement, although employers should bear in mind that if they pay the employee's medical insurance they are still liable for Class 1A NICs - also payable at 12.8 per cent - so there will be no immediate cost savings. However, it is a good way of keeping staff happy, as taking out such cover privately can be prohibitively expensive for employees.

Companies that already offer private medical insurance as a voluntary benefit to employees and deduct the premiums from net pay to cover the cost will save money by providing it under salary sacrifice. Employees may also find it a cost-effective way of purchasing additional family cover, which is normally paid for by deductions from net pay.

While there are potential savings to be made on National Insurance contributions by offering a salary-sacrifice scheme to staff, employers should be aware of the risks involved in setting up one. The Inland Revenue does not give guidance on setting up salary-sacrifice schemes and will not approve the arrangement until the scheme has been established. But it will be interested in a scheme once it is set up, so the employer should ensure it provides its tax office with full details of the new scheme and the contractual arrangements.

The tax inspector will want to be satisfied that in exchange for a non-cash benefit, the employees who have signed up to salary sacrifice have had their cash remuneration reduced contractually. If there is not a contractual reduction in pay, the inspector will require the employer to subject the full value of the benefit to PAYE tax and Class 1 NICs.

The Inland Revenue is also on the look out for employers who appear to be encouraging a mass exodus of staff to salary sacrifice in order specifically to avoid paying National Insurance.

Before entering into a salary-sacrifice scheme, the Inland Revenue recommends that employers seek legal advice on whether the proposed arrangements will receive the desired result. It is also worth remembering, warns Eamonn O'Connor, managing director of the Gissings Consultancy employee benefits group, that Inland Revenue rules on NIC savings could change at some future date. 

Further Information

For more information on salary sacrifice, see the Inland Revenue's website www.inlandrevenue.gov.uk . To find whether it can benefit your business and the impact it will have on your employee costs, check BDO Stoy Hayward's free online calculator at www.bdo.co.uk

Biography

Melanie Bien has been personal finance editor and property correspondent of the Independent on Sunday since December 1999. She is author of Renting Out Your Property for Dummies, Buying and Selling Property for Dummies and Buying a Home on a Budget for Dummies (all published by Wiley). She started her journalist career on The European, where she was markets editor for two years, and has also worked on several FT-owned publications, including Resident Abroad, Financial Adviser and FT Mandate.