Novated lease

Salary packaging and novated leases

In salary packaging an employer enters an arrangement to provide non-cash benefits to their employees in order to reduce income taxes paid by the employee on that salary, while still providing the same net benefit. A novated lease is a way of providing the benefit of the use of a motor vehicle for an employee via salary packaging without the employer having to actually own the vehicle and also allowing the vehicle to move from employer to employer with the employee.

Tax treatment of a novated lease

In Australia, non cash benefits provided to an employee are regarded as fringe benefits and employers must pay fringe benefits tax (FBT) on the value of these benefits at a rate equivalent to the highest marginal income tax rate. Since after novation of the lease the employer is now paying the running costs of the vehicle, use by the employee of that vehicle is a fringe benefit.

Cars are treated in a concessional manner by the fringe benefits legislation and rather than using the actual running costs, the value of the fringe benefit can be set at 20% of the original purchase price of the vehicle, less stamp duty, motor vehicle registration and Compulsory Third Party Insurance.^[1] This concessional treatment assumes some business use of the provided motor vehicle, but business use is not actually required. Other vehicles such as commercial vehicles, utilities and motorbikes are not subject to this treatment, but may be exempt from FBT under certain circumstances.^[2]

The fringe benefit value may be reduced to two thirds of the original value at the start of the FBT year (1 April) following 4 full years since the purchase of the vehicle by the lessor. As most novated leases are for 5 years or less, this has a limited effect.

In addition, if the employer is registered for goods and services tax (GST) they can claim an input tax credit equal to the amount of GST they have paid as part of the running cost. This reduces their net cost, and in the case of a salary packaging arrangement, the corresponding decrease in employee salary will also be reduced.

Generally an employer also would expect their employee to reimburse the FBT the employer must pay, so the reduction in employee salary becomes equal to the total running costs paid by the employer, less GST, plus any FBT.

Employee contribution method (ECM)

The methods of valuing the fringe benefit for a car or other motor vehicle allow a contribution from the employee toward the running costs to offset the fringe benefit.^[3] Since the employee is now directly paying for some of the costs, this reduces the income tax and GST benefits, but because FBT, equivalent to the highest marginal tax rate, is eliminated, the net cost to the employee of the arrangement is less. The employee contribution can take either the form of direct payment for expenses or can be paid to the employer. Since the maximum benefit is obtained by making a contribution of exactly the amount of the fringe benefit (eliminating all FBT), usually the latter is used. In this case, the employer must remit GST on the employee contribution to the ATO. Thus the reduction in employee salary becomes equal to the total running costs paid by the employer, less GST on those costs, less the employee contribution, plus GST on the employee contribution. In addition, the employee contribution is paid to the employer from the salary on which income tax has already been paid.

The employee contribution method increases the amount of income tax and GST paid by the employee because less is paid by the employer. This increase in tax is almost always smaller than the FBT being eliminated, even considering the tax saved by the reduction in salary due to paying FBT, and so the net cost to the employee is reduced.

GST on the purchase price of a vehicle

In salary packaging advertising material, a benefit frequently claimed is that the employee does not pay the GST component of the purchase price of the vehicle.^[4] This is technically correct, since it is the finance company (lessor) actually purchases the vehicle and pays the GST, not the employee. However, the statement is misleading, implying that the net cost to the employee is reduced by the amount of GST on the purchase price if they buy a car via a salary packaged novated lease.

GST must be included in the lease rentals and the residual by the lessor, which actually increased the total amount of GST to be paid, especially when GST exempt items such as stamp duty are bundled in the lease. GST on the residual is paid by the employee if they keep the car at the end of the lease. GST on the rental payments can be claimed by the employer as an input tax credit, but if the ECM is used to offset the fringe benefit, then the GST owing on the ECM payments offsets the input tax credit. Since claiming the GST on running costs other than lease rentals, such as fuel, is also claimed as a benefit of salary packaging a novated lease, in reality the employee salary packaging a novated lease with ECM usually ends up paying more GST on the purchase of the vehicle that if they had bought it outright. If the ECM is not used, all the GST except that on the residual could be claimed by the employer, but the additional cost of paying FBT is always greater or equal to any possible GST benefit.

Residual values and the end of a lease

At the end of the lease, the lessee is required to return the vehicle to the lessor, however most lease contracts have as the penalty for failing to return the vehicle a payment of the amount of the residual value to the lessor. In effect, this means the lessee can purchase the vehicle from the lessor at the residual value at the end of the lease. The residual value is a depreciated value of the vehicle defined by the contract, although because it is determined at the start of the lease, it may not be the actual market value of the vehicle. There will often be a term in the lease contract that requires the lessee to make good any shortfall between the residual and the market value of the vehicle. Since the residual includes GST and is not paid by the employer (resulting in a tax saving), it is beneficial to the employee have a lower residual value and to pay higher rentals during the lease. For this reason, residuals are usually set at or near the minimum allowed by the Australian Taxation Office.^[5] In general this means that the market value of the vehicle exceeds the residual, resulting in additional benefit to the employee which is not subject to FBT.^[6]

Third party salary packaging companies

In Australia, salary packaging arrangements are often outsourced to third party salary packaging companies to reduce administrative load on the employer. In those cases, when a motor vehicle is salary packaged with a novated lease, the third party arranges the purchase and finance of the vehicle (via a lease - usually through a third party financier), the novation, GST and FBT accounting, and budgeting for, and paying of, all running costs in exchange for a management fee, and possibly rebates/commissions from suppliers. The third party arranges for regular payments from the employer (and employee, if ECM is being used and paid directly to the employer) to cover the budgeted running costs (including their fee). These payments appear in a "salary packaging account" which shows the budget, payments in, and running costs being paid out. In addition, the employee may directly pay suppliers for running costs and then be reimbursed from "their" salary packaging account by the salary packaging company.

Confusing use of the term "novated lease"

While the novated lease is only a part of the salary packaging arrangement, the whole arrangement is often described as a "novated lease" even though the term strictly applies only to the lease for the finance of the vehicle which has been novated. This usage of "novated lease" is almost universal on documentation, advertising and the websites of salary packaging companies and leads to confusion about whether it is the whole arrangement or just the lease itself which is meant by the term.

Often the employee deals only with the third party for the entire process, with no interaction at all with the financier or the employer. In addition, the running costs appear on their pay slip as deductions, with costs paid by the employer shown as "pre-tax" deductions and employee contributions as "post-tax" deductions. It therefore appears to the employee that they are directly paying all the running costs of the motor vehicle (albeit in some strange tax beneficial way), even though strictly the employer is paying for all or part of those costs. In addition, the leased vehicle is effectively their personal vehicle, chosen by them, available for their exclusive use, and they have the option to purchase it at the end of the lease by failing to return it and paying the penalty.

It is frequently considered by employees that a salary packaging arrangement including a novated lease is a loan for the vehicle which includes non-finance running costs.^[7][8] This confusion is compounded by salary packaging companies and finance companies who quote interest rates for leases.^[9][10]

Types of novated lease

This confusion extends to the terms used by salary packaging companies to describe different salary packaging arrangements which include a novated lease.

The first term is fully maintained novated lease, describing the most common type of salary packaging arrangement, where a finance lease is novated so the employer pays the lease rentals but also pays all other running costs (excluding the effect of employee contributions).^[11] This terminology is confusing as outside of salary packaging, a fully maintained lease, describes an operating lease where the lease contract includes in the rental payments the fixed running costs of a vehicle or asset, such as insurance, registration, servicing and roadside assistance as well as some variable costs like fuel and tyres.^[12] The lessor simply hands back the vehicle at the end of the lease with the lessor assuming the residual value risk. There are usually terms in the contract with penalties or fees to protect the lessor from excessive costs and depreciation of the asset. Thus, a fully maintained novated lease is not a novation of a fully maintained lease.

It is of course possible to novate a fully maintained lease; this may be called a fully maintained novated operating lease .^[13]

To make things more confusing, it is also very common to include up front costs over and above the purchase cost, such as stamp duty, registration, the first year's comprehensive insurance, extended warranties and other insurances and fees, into the lease in a fully maintained novated lease, since there will not have been sufficient time to set up the payments by the employer into the salary packaging account to cover those costs. For this reason it is also common for novated leases to have deferred payments, that is, the first one or two rentals are set at $0, with the remaining rentals increased to compensate.

The third type of lease is described as a novated finance lease or non-maintained novated lease where only the novated lease itself is salary packaged, with none of the other running costs such as fuel, insurance or maintenance being paid by the employer.^[14] This arrangement is of little or no benefit to the employee as there is no change to the fringe benefit value, being based on the original purchase price, but any tax benefits on the other running costs are lost as they are not salary packaged. The effect of paying FBT or using ECM offsets most or all the potential tax benefits from salary packaging the lease rentals alone.

Benefits and pitfalls of salary packaged novated leases

For the employee:

• Income tax and GST savings:

While a salary packaged novated lease has the potential to yield tax benefits for the employee, providing net savings on the overall cost of purchasing and running a motor vehicle, the complexity of the process and lack of transparency makes it difficult for most people to evaluate the extent of the benefits. Salary packaging companies will usually provide a comparison stating projected savings, but this only compares leasing the vehicle with the same estimated costs without the benefit of salary packaging. This is unlikely to be how a motor vehicle would actually be purchased in Australia, in most cases a car or personal loan or some other source of funds such as savings or redraw from a home mortgage would be used. Additional costs of leasing and fees can mean the raw running costs of a salary packaged novated lease are significant higher than the equivalent costs of private ownership with a loan, but with the benefits of tax savings, the net cost can be lower. In addition, tax deductions for any business use of a vehicle are specifically disallowed for a salary packaged novated lease.

• Access to volume discounts if the employer/salary packaging company has many vehicles under this scheme:

Salary packaging companies often claim access to fleet discounts on the purchase price of vehicles that are not available to individuals. In some cases these may be only on specific makes or models of vehicle, and may be no greater or even lower than discounts which can be negotiated by an individual with a dealer. There is generally no reason why an individual cannot negotiate an acceptable purchase price, then arrange a lease which is then novated and the vehicle salary packaged. Significant savings can be obtained by salary packaging a novated lease on a cheaper used or demonstrator vehicle. Additional volume discounts may also be available on insurance or servicing arranged by the salary packaging company, but contrariwise, they may be more expensive than those privately arranged.

• Perceived benefits that are greater than actual benefits:

Advertising by salary packaging providers emphasising the tax benefits of a salary packaged novated lease, the out of sight nature of salary reduction/deduction and a lack of understanding of how salary packaging actually works may induce employees to lease vehicles with costs far in excess of what they would ordinarily spend, or to continually revolve leases with the mistaken impression that the cost is equivalent or lower than keeping their existing car.

• Convenience of third party management:

There is a perceived benefit in not having to budget or worry about paying for running costs, especially large once per year costs. However budget shortfalls are common complaints in salary packaging, and much of the paperwork load is the same in salary packaging, or even greater if reimbursement requests are required.

• Flexibility in the choice of a car compared to a company car arrangement
• Vehicle stays with the employee and can be transferred to a new employer:

However the counter to this is if the employee wants or needs to sell the vehicle during the term of the lease, breaking the lease contract can be very expensive, sometimes far in excess of the current market value of the vehicle.

For the employer:

• A way to provide an effective increase in employees' salaries with no or minimal cost to the business
• A cost effective alternative to operating a fleet of company vehicles
• Compared to company cars, the business does not assume any risk for the vehicles
• Compared to company cars, employee vehicles are "off balance sheet"
• Compared to company cars, the employer is not stuck with the vehicle if the employee leaves.

For the service providers:

• They provide various services for fees and/or commission.