What Is a Novated Car Lease and How Does It Work?

A novated car lease is a three-way financing agreement for a vehicle. It involves an employee, their employer, and a finance company. This arrangement allows an employee to acquire a vehicle with payments often deducted directly from their salary package. The employer takes on responsibility for the lease payments on behalf of the employee. This financial tool is commonly associated with salary sacrificing, where a portion of an employee’s pre-tax income is allocated towards the vehicle’s costs.

Understanding the Parties Involved

A novated lease involves three parties. The employee selects the vehicle and is its primary user. They use the vehicle for personal and, if applicable, business purposes. The financial and administrative aspects are largely managed by the other parties.

The employer facilitates this agreement. Instead of the employee making direct payments, the employer agrees to make the lease payments and other associated costs to the finance company. This is achieved by deducting these amounts from the employee’s gross salary, a process known as salary packaging or salary sacrifice.

The finance company, or lease provider, is the legal owner of the vehicle throughout the lease term. They purchase the car on behalf of the employee and then lease it to the employee via the employer. The finance company sets the lease terms, including the duration and the residual value of the vehicle at the end of the lease. If the employee changes employers during the lease term, the novated lease agreement allows for the lease to be transferred to the new employer, provided the new employer agrees. If a transfer is not possible, the lease obligations revert directly to the employee.

Financial Mechanics of a Novated Lease

The financial structure of a novated lease offers benefits through salary packaging. This arrangement involves the employee agreeing to a reduction in their gross salary in exchange for the employer covering the vehicle lease and running costs. A portion of these deductions can be made from the employee’s pre-tax income, which effectively lowers their taxable income.

While “salary sacrifice” or “salary packaging” are terms often used with novated leases, understanding the tax implications is important. In the United States, employer-provided vehicle benefits are subject to specific tax rules. The personal use of an employer-provided vehicle is considered a taxable fringe benefit, and its fair market value must be included in the employee’s income. The Internal Revenue Service (IRS) provides methods for valuing these benefits to determine the taxable amount.

The concept of Fringe Benefits Tax (FBT) is a tax imposed on employers for certain non-cash benefits provided to employees in other countries. In jurisdictions where FBT applies, novated leases can trigger this tax because the employer provides a car for the employee’s private use. In the US, there is no direct equivalent to FBT. Instead, the value of the personal use of an employer-provided vehicle is directly added to the employee’s taxable wages. This means the employee’s income tax, Social Security, and Medicare taxes apply to this benefit.

Inclusions and Exclusions

A novated lease bundles various vehicle-related expenses into a single payment. Commonly included costs are the vehicle’s finance payments, fuel, scheduled maintenance and servicing, insurance premiums, and vehicle registration fees. These expenses are budgeted for the lease term and deducted from the employee’s salary alongside the lease payments. This simplifies budgeting and management for the employee.

There are two main types of novated leases: “fully maintained” and “unmaintained” or “self-managed” leases. A fully maintained novated lease encompasses the vehicle’s finance and almost all its running costs, providing a comprehensive package. This means the employee does not need to worry about separate bills for fuel, servicing, or insurance, as these are integrated into the salary deductions. This offers a predictable monthly outlay for vehicle expenses.

In contrast, an unmaintained or self-managed novated lease primarily covers only the vehicle finance. Under this arrangement, the employee remains responsible for managing and paying for all other running costs, such as fuel, maintenance, and insurance, directly from their post-tax income. While this option leverages the pre-tax deduction for the lease component, it does not offer the same administrative convenience as a fully maintained lease. Certain costs, like traffic fines or vehicle modifications not part of the initial agreement, are excluded from any type of novated lease and remain the employee’s responsibility.

Lease Completion Options

As a novated lease term concludes, the employee has several choices regarding the vehicle. One option is to pay the residual value of the vehicle and assume full ownership. The residual value, also known as the balloon payment, is a pre-determined lump sum representing the vehicle’s estimated value at the end of the lease period. Upon paying this amount, the title transfers from the finance company to the employee.

Another alternative is to re-lease the vehicle for a new term. This involves negotiating a new novated lease agreement with the finance company and employer. This option allows the employee to continue using the same vehicle under a renewed salary packaging arrangement. The new lease term and associated payments are re-calculated based on the new agreement.

A third choice is to trade in the vehicle for a new novated lease. In this scenario, the employee acquires a different vehicle. The existing vehicle is used as a trade-in to help cover its residual value or contribute towards the new lease. The process involves returning the old vehicle and initiating a new three-way agreement for the chosen replacement.