Salary sacrifice – the taxman’s getting testy

Although salary sacrifice schemes are not rare, there are those who seek to push the boundaries – and the taxman’s patience is wearing thin. By TERRY HAYES

By Terry Hayes

Although salary sacrifice schemes are not rare, there are those who seek to push the boundaries – and the taxman’s patience is wearing thin.

From time to time, the tax office warns taxpayers about concerns it has with arrangements that threaten revenue. These warnings come in the form of what are known as taxpayer alerts.

Recently, the tax office released warnings concerning employee savings (salary sacrifice) plans, and salary deferral arrangements.

Commissioner Michael D’Ascenzo says people involved in or considering these schemes should be warned they face close examination by the tax office. These schemes are variations on ones that have concerned the tax office before, and the Commissioner says he is considering whether the promoter penalty laws should be applied to people promoting them.

The urge to reduce tax can be strong, but there are limits within the law that must be observed. Otherwise, participants in these schemes invite a visit from the taxman.

There are many acceptable and entirely legal salary sacrifice arrangements in place, which the tax office accepts as meeting the requirements of the law. Indeed, valid salary sacrifice arrangements are a very tax effective way to structure remuneration.

However, although they have been around for a long time, there are those who seek to push the boundaries.

Tax office alerts not only serve to warn, but also shed light on what the taxman is thinking and why it has concerns about certain schemes. That can be very useful pointer for taxpayers.

Employee savings plans

One tax office alert concerns the use of employee savings plans. These schemes use a trust structure to attempt to convert salary or wages income into a capital gain, to reduce tax.

The features of the scheme in question are a little complicated, but illustrate the lengths that some taxpayers will go to in order to save tax.

Under a salary sacrifice arrangement, an employee directs (or requests) that future salary or wages or bonus income otherwise payable by their employer be paid to a discretionary unit trust.

An amount equivalent to the salary sacrificed is contributed to the trust and ordinarily held by the trustee as an unallocated capital contribution.

On receipt of the contribution or shortly thereafter, the trustee makes a loan to the employee. The amount of the loan is equal to the amount previously contributed to the trust. The loan is ordinarily interest-free.

The employee uses the loan to buy ordinary units in the unit trust.

As a unit holder in the trust, the employee may be entitled to trust income and may be issued with bonus units at the trustee’s discretion. The value of the bonus units issued will typically equal the salary previously sacrificed by the employee.

The employee may have to satisfy minimum holding periods and/or employment-related performance hurdles before the units can be redeemed.

When the holding period has expired and the performance hurdles are met, the employee may ask the trustee to redeem the units.

Upon redemption, the trustee will: (i) calculate the value of the ordinary and bonus units issued to the employee; (ii) offset that amount against the employee’s outstanding loan balance; and (iii) pay the balance of the proceeds to the employee.

The value of the bonus units will usually equal the outstanding loan balance, and therefore extinguish the loan. The employee will also redeem his or her ordinary units, which will usually equal the previously sacrificed salary plus any capital appreciation.

The tax office considers that an arrangement of this type gives rise to taxation issues, which include whether it is a bona fide salary deferral arrangement, and whether the arrangement is an effective salary sacrifice arrangement (in accordance with Taxation Ruling TR 2001/10).

The tax office is also concerned that the arrangement may constitute a scheme to which the general anti-avoidance rules of the tax law might apply.

Salary deferral arrangement

Another alert warns about certain salary deferral arrangements. These schemes involve employees deferring their salary and instead receiving a payment categorised as a loan, which is claimed not to be taxable. In later years, the employee is paid a salary that is offset against his or her loan.

The tax office considers the purpose of the arrangements is to convert salary and wage income to a form that is taxed concessionally or not at all – for example a capital gain, an employment termination payment or a loan.

The key features of this particular arrangement that have prompted the concern are:

The employee and employer agree to defer the entitlement or payment of salary or wages income (or a bonus). Instead, the employer provides a loan to the employee, ordinarily of an amount equal in value to the income deferred. The loan may or may not be on arm’s length terms.

The employee uses the loan to acquire an income-producing asset. The asset may be shares in the employer business or an associated entity of the employer. The asset may be offered as security for the loans and may be held within a trust structure.

After a fixed period of time, the employer applies the deferred income to the outstanding value of the loan. The application of the deferred income may occur after the employee has terminated employment with the employer.

The tax office considers that an arrangement of this type gives rise to taxation issues that include, similarly to the above scheme, whether it is a bona fide salary deferral arrangement, and whether the arrangement is an effective salary sacrifice arrangement.

The tax office would also consider whether the payment or crediting of deferred income subsequent to termination of employment is an employment termination payment for tax purposes.

As with the above arrangement, the tax office is also concerned that it may constitute a scheme to which the general anti-avoidance rules of the tax law might apply.

The end play

The saving of tax is a legitimate aim for any taxpayer. But beware that the end does not always justify the means – especially when the taxman becomes aware of what is going on!

Read more on tax schemes, anti-avoidance laws and remuneration issues

Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions.