Novated car lease: what is it and how does it work?

Depending on your situation there are a few different ways you can finance a new car, such as buying it outright (if you have the savings), taking out a car loan or agreeing to the finance offered by a car dealer. Another option is a novated lease.

A novated lease may help you finance the cost of a car, and possibly some running expenses too, while potentially reducing your taxable income, according to ASIC’s Moneysmart. So how does it work, and what are some of the pros and cons of this type of agreement?

What is a novated lease?

A novated lease (also known as ‘salary sacrificing’ a car) is a three-way agreement between you, your employer and a finance company. It works by you asking your employer if they will agree to make lease repayments on a car using your pre-tax salary. If they agree you can then take out the lease with a finance company (which may be chosen by your employer). From there it will be your employer’s responsibility to make the lease repayments directly to the finance company on your behalf.

Types of novated leases

There are typically two types of novated leases available – fully maintained and non-maintained. It’s up to your employer which type of lease, if any, they are willing to agree to.

1.  Fully maintained novated lease

If your employer offers this type of lease, both the purchase price of the vehicle (as well as any finance costs such as fees and interest) and its running costs (such as fuel, services, registration and car insurance) will be calculated into the repayments your employer takes out of your pre-tax salary.

For example, finance company may provide you with a fuel card to use at particular petrol stations, or get you to send them the bills for your registration or car servicing. When it comes to car insurance, depending on the finance company you use, they may arrange insurance through a preferred provider, or allow you to use an insurer of your choice.

2.  Non-maintained novated lease

Under this type of lease, only the purchase price of the vehicle plus administration fees and interest are calculated into the lease repayments taken from your pre-tax income. This means that you will be responsible for paying the running costs of the vehicle from your post-tax salary.

How do you apply for a novated lease?

To apply for a novated lease, you will first need to ask your employer if they offer this type of benefit.

Next, the finance company you or your employer chooses will usually liaise with you and your employer to set up the lease agreement (sometimes called a deed of novation), including determining the duration of the lease, how many kilometres you expect to travel each year (to help calculate running costs, if they are included in the lease) and the type of car you are after. These agreements must be made before your salary is deposited into your account, as you cannot salary sacrifice the cost of a vehicle after you’ve been paid. The ATO recommends that you and your employer clearly state and agree on all of the terms of any salary sacrifice agreement in writing.

novated lease agreement
Source: Andrey_Popov (Shutterstock)

The duration of the novated lease agreement can typically vary from one to five years and unless stipulated otherwise by your employer, you are usually free to choose the car you wish to lease, whether it’s new, used or, in some cases, even your existing car.

Once a novated lease is in operation, your employer will deduct the repayments from your pre-tax salary and pay it to the finance company. The ATO states that employees can renegotiate a novated least at any time, subject to the terms of their employment contract.

What happens at the end of a novated lease?

Once the novated lease period ends, there are several options you can consider, including:

1. Take out a new lease with a new car

If you want to upgrade to the latest model, you can do so by trading in your current leased vehicle and using the money from the trade to pay out the residual value of the car (which is what the car is worth at the end of the lease term). Once you have paid the residual amount you can then enter into a new lease agreement for the new car.

2. Extend your current lease

You may be able to extend your current arrangement with the same car by refinancing the lease based on the vehicle’s residual value. However, it is important to consider the reliability of your current vehicle (as cars can experience mechanical issues as they age) before choosing this option.

3. Buy and keep the car

If you want to keep the car you have been leasing, you can usually purchase it by paying the residual value, often referred to as a balloon payment, to the finance company plus GST.

4. Sell the car

You also may be able to sell your leased car and use the money from the sale to pay the residual value. Your finance company or fleet provider may be able to assist with the sale of the vehicle.

How does a novated lease work with tax?

When you make repayments on a vehicle through your pre-tax salary, those repayments can reduce your taxable income and potentially lower the amount of tax you are required to pay each year, according to ASIC’s Moneysmart. As well as this, the Australian Taxation Office (ATO) states that goods and services tax (GST) does not apply to novated leases in the same way as it does to other types of car purchases. This means that the purchase price of the car, which your lease repayments are partly based on, could be lower with a novated lease than if you were buying the car outright. That said, you would need to factor in the overall cost of the lease, including fees and charges, before determining whether you would end up better off in the long run.

The Fringe Benefits Tax (FBT)

There are tax implications for your employer when you receive what the government calls a ‘fringe benefit’ – such as a car through salary sacrificing.

The ATO states that your employer must pay a fringe benefits tax (FBT), which is calculated on the taxable value of the fringe benefits (e.g. the leased car). Your employer will need to calculate how much FBT they need to pay for the FBT year (1 April to 31 March) and lodge an FBT return.

Does the FBT affect employees?

While it is your employer who is liable to pay the FBT, they may choose to reduce your salary by the amount of FBT they pay, depending on your salary sacrifice agreement.

In addition, if the total taxable value of your fringe benefits (e.g. your vehicle purchase price and running costs) exceeds $2,000 in an FBT year, the ATO said your employer must report the total value of the benefits on your end-of-year payment summary at tax time. Although you will not have to pay tax or a Medicare Levy Surcharge (MLS) on the total of your fringe benefits, the ATO said this amount will be included as assessable income for calculating your eligibility or liability for things such as the MLS, tax offsets, private health insurance rebates or child support payments.

To help reduce the impact the FBT may have on your salary or on your assessable income, the ATO said you can reduce the total fringe benefits amount by making employee contributions out of your post-tax income. For example, you could use your post-tax income to pay for some of the running costs of the car (such as fuel), and these costs would then be excluded from the total fringe benefit amount your employer is required to report.

By using your own post-tax contributions to reduce your total fringe benefits amount you can also help to lower the amount of FBT your employer is required to pay or potentially eliminate it all together.

Pros and cons of a novated lease

There are some pros and cons of a novated lease to consider before agreeing to this type of arrangement with your employer. Some of these pros and cons may include:

Pros

  • Tax benefits

According to the ATO, novated lease repayments made through your pre-tax salary could reduce your taxable income. You can also avoid paying GST on the purchase price of the vehicle (which is factored into your lease repayments) when you’re not buying it.

  • Consolidated payments

With a fully maintained novated lease, all of your car expenses are simplified into a single regular deduction from your pre-tax salary, which is managed by your employer and the finance company. This means you don’t have to come up with a large upfront payment for the vehicle or juggle multiple car bills at different times throughout the year, which could make it easier to budget.

  • Opportunity to upgrade

You typically will have the option to trade in your vehicle at the end of the lease for a newer or different model, without having to go to the effort of selling your old car.

upgrade car lease
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Cons

  • You don’t own the car

Under a novated lease you do don’t technically own the vehicle. This means you are unable to make any alterations to it, and cannot claim the car as your own asset for other borrowing or financial purposes.

  • Residual value due at end of lease

The repayments for a novated lease do not cover the whole car amount over the term of the lease. This means you are required to pay the residual value of the car at the end of the lease, unless you renew the lease. Depending on your lease term and the original cost of the car, the residual value you must pay may be significant. This may be covered by the sale of your car at the end of the lease, or you will be required to pay it if you choose to keep the car and do not enter another novated lease.

  • You might liable for the car if you lose or change your job

If you lose your job, you may be able to take your novated lease with you to your new employer. However, if your new employer does not agree to this benefit or you do not move to a new job, you are the one liable for paying for the car. This means you must continue either making repayments to the finance company or terminate the lease agreement altogether and pay any early exit fees that may be charged, plus the residual value of the vehicle.

  • Administration fees and higher interest rates

Novated leases often come with administration fees that are calculated into your repayments. The interest rate you pay on a novated lease may also be higher than those offered through a normal car loan, according to carsguide.

A novated lease has its benefits and drawbacks, and whether or not it is suitable will depend on your circumstances. Before entering into a novated lease contract with your employer, it’s important to understand its contractual implications, and calculate if you can afford the repayments coming out of your pre-tax salary, plus the payment of the residual amount at the end of the lease.

Cover image source: Syda Productions (Shutterstock)

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