Timing is crucial when it comes to salary sacrificing leave entitlements.
The Commissioner’s view on the taxation implications of salary sacrifice arrangements is discussed in Taxation Ruling TR 2001/10.
A salary sacrifice arrangement is an arrangement between an employer and an employee whereby the employee agrees to forgo part of their future entitlement to remuneration in return for a benefit of a similar value. The consequence of such an arrangement is that the employee is assessed on the reduced amount of the salary received and the employer is liable for any fringe benefits tax payable on the benefit provided.
Where an employee directs an entitlement to receive salary or wages that has been earned to be paid in a form other than as salary or wages, the salary sacrifice arrangement is ineffective. Benefits provided under an ineffective salary sacrifice arrangement are generally regarded as assessable income.
Once an employee has earned an entitlement to receive an amount of salary or wages, any income later received by the employee from that entitlement or taken to be received on behalf of the employee is derived as salary or wages income.
In light of the above, and in regard to an accrued leave entitlement, if the leave entitlement has been earned then it cannot be salary sacrificed – refer paragraphs below from TR 2001/10:
- Payments made under an ineffective … [salary sacrifice arrangement (SSA)] to, or on account of, an employee are ordinary or statutory income derived by the employee at the time of payment for the reasons stated in paragraph 25 above. Benefits provided under an ineffective SSA are assessable income of the employee under section 6-5 or 6-10 of the ITAA 1997 and they are not exempt income under section 23L of the ITAA 1936. To deal with an entitlement to take leave that has already accrued will be an ineffective SSA. The exchange of an entitlement to take leave for another benefit will cause the entitlement to be paid as salary or wage and to be derived as ordinary income.
- Benefits provided to or on behalf of an employee under an effective SSA may be derived as ordinary or statutory income by the employee. Any such benefits that are convertible to money are derived by the employee as ordinary or statutory income. However, these benefits are not assessable income of the employee under section 6-5 or 6-10 of the ITAA 1997 because they are exempt income under section 23L of the ITAA 1936. Leave that will accrue from the provision of future services may be the subject of an effective SSA. Similarly, the taking of leave that accrued prior to the commencement of the SSA in the ordinary course of employment will not cause the SSA to be ineffective.’
An effective arrangement is not possible unless the agreement was entered into prior to the leave entitlement accruing. In TR 2001/10Zthe Commissioner further states:
’89. Once an employee has completed the relevant qualifying period of employment and has an entitlement to take annual leave, long service or sick leave, the employee has an entitlement to be paid salary or wages. An entitlement to take leave is synonymous with an entitlement to be paid salary or wages because the employee has done everything necessary, apart from taking the leave, to be entitled to be paid.
- It then follows that a SSA exchanging an entitlement to take leave that is accruing, or that has accrued, for past services performed in return for benefits is ineffective. Benefits paid under an ineffective SSA are payments of salary or wages and form part of the employee’s assessable income under section 6-5 or 6-10 of the ITAA 1997.
- We recognise that a SSA exchanging any expected entitlement to leave that will accrue for future services rendered in return for benefits will be effective. While benefits provided under an effective SSA may be derived as ordinary or statutory income by the employee (see paragraph 28 above), the income is exempt because of the operation of section 23L of the ITAA 1936.’
In Wood v. FC of T 2003 ATC 2006, it was held that a taxpayer failed to enter into an effective SSA when he directed his employer to pay his accrued performance-related bonuses and long service leave entitlement to a superannuation fund. The taxpayer had merely directed that entitlement to income that had already been earned to be paid in a form other than salary or wages and he remained assessable on that amount.
In Heinrich v FC of T 2011 AATA16 the taxpayer was employed in the aviation industry and had his remuneration packaged in a ‘salary sacrifice’ arrangement, that is, the first $2,000 of his fortnightly remuneration entitlement was paid into a superannuation fund. When the parties entered into the agreement to forgo salary in exchange for superannuation contributions, they did not specifically agree to forgo annual and long service leave entitlements. The taxpayer’s employment ended on medical grounds whereupon he received a payment in respect of his unused annual and long service leave entitlements.
The taxpayer subsequently sought a ruling that part of the payment he received be treated as it would have been treated had his salary sacrifice arrangement continued. The Commissioner ruled unfavourably, determining that the payments were properly assessable income to him.
The taxpayer then sought a review by the Administrative Appeals Tribunal (‘AAT’). The AAT held that the payment of unused annual leave and long service leave entitlements following the termination of a taxpayer’s employment was not covered by an effective salary sacrifice agreement. The AAT held that once the conditions for the taxpayer’s entitlement to the payments had been satisfied, the amounts were the taxpayer’s assessable income as unused leave payments.
The following example, which is taken from the ruling, highlights the difference between an effective an ineffective salary sacrificed leave entitlements (note dates have been edited from those in the original ruling example):
‘Example 6 – partially effective SSA involving leave
David Citizen negotiates a SSA for the … [2020-21] year of income with his employer at the close of business on 30 June … in relation to his annual leave. The SSA seeks to apply to his leave that has already accrued, together with future leave that will accrue. There are no restrictions under the relevant industrial law, etc., that limit the amount of annual leave that David can forego in exchange for other benefits. As at 30 June … , David has an entitlement to annual leave of 4 weeks for services performed in the period 1 January …  to 31 December … . David has also accrued annual leave of 2 weeks for the period 1 January …  to 30 June … , although he is not entitled to take this leave until 1 January 2021. David would, however, receive payment of the leave entitlement if he were to resign prior to 1 January 2021.
Expense payment reimbursements received by David in exchange for his accrued leave of 2 weeks annual leave and the presently available 4 weeks of annual leave represent the payment of entitlements to leave which have been earned. They cannot be the subject of an effective SSA. The expense payment reimbursements are taken by subsections 6-5(4) and 6-10(3) of the ITAA 1997 to be derived as income. David’s employer will have no liability to pay FBT on the benefits provided but will be required to withhold an amount to meet the PAYG withholding obligations.
Expense payment reimbursements received by David in lieu of the entitlement that he has foregone for leave accruing after 30 June …  represent benefits received under an effective SSA and do not form part of David’s assessable income. David’s employer is liable to pay FBT on the benefits provided.’
The fundamental takeaway for our employer members is that a for a salary sacrifice arrangement dealing with future accrued leave to be effective, it must be entered into prior to the leave accruing.
The paperwork supporting the arrangement must clearly specify that future leave entitlements that will accrue can be salary sacrificed.