When entering into a novated lease arrangement it can be easy to have fireworks going off in your head about getting that new car. However, there are a few cautions to be aware of for both the employee, and the employer. Most people don't pay attention to tip number 4.

If you are in the market to purchase a new car and want to purchase it using a novated lease arrangement, there are a few things you would want to consider from both your employer’s perspective, and your own prior to entering into the arrangement.

What is a novated lease?

A novated lease arrangement involves 3 parties: the employee, the employer and the financier. The arrangement has been initiated by the employee who seeks to purchase a car from a car dealership and does so by getting a loan from the financier (which could also be the car dealership).

The employee then novates the lease payments of the car to the employer by agreeing to apportion an amount of their pre-tax salary.

The arrangement seems harmless enough, so what are the dangers to be mindful of:

Tip #1 (Employers) - Provision for the Pending FBT Liability

For the employer its important a portion of the employee’s salary is to be withheld to cover the Fringe Benefits Tax (FBT) liability.

The Fringe Benefits Tax is payable by the employer, not the employee. Therefore, it’s important to collect from the employee the projected Fringe Benefits Tax in the salary packaging arrangement.

Also, once an employer has submitted an FBT return there will be an additional FBT provisional charge included automatically by the ATO to help cover for the subsequent FBT year ahead.

This can help to reduce the cash flow burden of paying a lump sum at the end of the FBT year, but it’s important for the employees to know that a portion of their salary will also be used to help cover the employer’s FBT liability.

If the employer is using a salary packaging provider to manage the salary packaging arrangements of their staff then the provider should be calculating the FBT to withhold. If the employer doesn’t have such a provider then it would need a competent accountant or payroll person to administrate and manage the calculation of the FBT to withhold.

Tip #2 (Employees) - Check if Purchase is Viable After FBT Provision

A rough guide of the likely amount of FBT your non-rebatable non-exempt employer is likely to withhold from your pay is to calculate 20% of the cost of the car that you wish to purchase through a novated lease.

For example, if you’d like to purchase a car that will cost $80,000 then 20% of this amount will be $16,000 and will therefore need to be withheld by your non-rebatable non-exempt employer to cover the likely FBT liability for the year.

If you employer is rebatable then this amount is roughly halved (up to a capped limit), and if your employer is exempt then no FBT will be charged, but again there are limits - feel free to check this page out on the ATO website .

Therefore, besides the lease rental payment to the financier being paid from pre-tax earnings, you would also need to sacrifice an additional amount ($16,000 over the course of the FBT year with our example) to pay for the privilege of having this car!

Tip #3 (Employers) - Additional Payroll Processing

Even if an employer elects to use the services of a third party salary packaging provider there is still needed someone in payroll to create the necessary payslip components that remit funds to the proper accounts.

While this administrative burden is not as costly as administering salary packaging in house there will still be some education and direction needed by the payroll team. A good salary packaging provider will be able to assist payroll staff with this process, or if the employer already has a capable payroll team.

Besides the payroll processing it should also be noted that there will need to be someone allocated to perform the FBT return at the end of March (you have until 21 May). This could be outsourced, but would require additional costs, or, if using the services of a salary packaging provider they are likely to provide the details needed to be input on the FBT return. Check with any chosen salary packaging provider for details.

Tip #4 (Employees) - Ready for High Interest Rates?

As financiers are a party to the agreement there is high risk which the financier needs to offset and this is reflected in the high interest rate charged. It is not unusual to see interest rate charges around 20% per annum for the privilege of salary packaging your car!

For assets such as houses they are less risky due to the general nature of real estate to appreciate over time. Unfortunately for motor vehicles we all know that over time these assets tend to depreciate and worth less than when we initially bought them.

This poses a risk for the financier in that should the employee default to pay they have an asset on their books that is depreciating quickly.

A way to minimise the high interest rate is to shop around for your financing to see if you can get a better deal either from your bank, or the manufacturer of the car, or the car dealership. Do be mindful that if you are seeking to salary package this arrangement you will need to make sure that you have a Deed of Novation and your employer (or salary packaging provider) may have other requirements too - so check with them before signing on any dotted line.

Tip #5 (Employees) - Are you on Probation?

If you’ve just started out with your employer you are likely to be on probation. It can therefore be quite a risk to you if you enter into a novated leasing arrangement and the arrangement between you and your employer doesn’t work out and you are let go without much notice.

This would mean you would need to either continue to pay the novated leasing company out of your own cash reserves or to quickly find a job where you can transfer the novated lease arrangement to the new employer.

While it’s tempting to enter into a novated lease arrangement and to drive a shiny new car it’s probably best to wait until your probation period is over.

Tip #6 (Employees) - Watch the Balloon (or Residual) Payment

Always check the balloon payment that you would need to make at the end of the novated arrangement.

The ATO has specific rules on what the residual payment needs to be depending upon the life of the lease arrangement.

For example, if I have a 3 year novated lease on a $30,000 car then according to the residual values determined by the ATO I would have to pay at the end of the lease period $15,678.

To counter this cash payment at the end of the lease period you could arrange with the financier to enter into a new lease agreement for another period. Check what options are available to you with the financier and understand what obligations and costs are incurred at the end of the initial lease period.

Tip #7 (Employees) - Tax Free Gain on Sale of Vehicle

One strategy you could use with your novated lease as it nears the end of its term is to look at selling the car and to pocket the difference between the residual value and the sale price of the car.

For example, continuing on with our previous example with the $30,000 car that has a residual payment of $15,167 - if I sold this car prior to the end of the lease term for $20,000 then I pocket the difference of X.

Obviously this implies you would need to be wise on the choice of car you buy and you would need to maintain it in good condition to make sure it can be sold for a good price.

Tip #8 (Employees) - Trade-in or Put a Deposit Down to Minimise FBT

It may also help if you can put a good sized deposit down on the financier to help mitigate some of the risks and pitfalls we have outlined above.

Doing so will also help to reduce the FBT that the employer is taking from your pay to help provision for the FBT liability coming at the end of March.

For example, if I don’t put down a deposit on a $30,000 car then my non-rebatable non-exempt employer will be provisioning 20% or $6,000 from my pay over the course of the year. If though, I trade-in a car or put a deposit down of $10,000 then the employer only needs to provision 20% on $20,000 being $4,000.

Tip #9 (Employees) - Look Out for Insurance Charges

Just as you pay mortgage insurance on your house when there isn’t enough equity in your home to reduce the risk of the bank foreclosing on your house and recovering the amount loaned to you, so too does the same principle apply for a novated lease. The financier is taking a risk that you will pay back the amount loaned to pay for your car.

To cover their risk you will likely have to pay leasing insurance to cover the repayments of the loan in cases where you may lose your job, or be on unpaid sick leave and cannot cover a repayment.

Conclusion

Hopefully within this article you’ve been able to think of some of the dangers and pitfalls with novated leases that can help you make the right decision before entering into an arrangement.

While there is an obvious benefit for cars that hold their value over time it still pays to check what all your alternatives are when seeking to purchase a new car.

One such arrangement that I prefer is an associate lease , but this may not work for some as either they are not married or have a spouse that earns more income than they do. If an associate lease doesn’t work well for you then I would encourage you to be aware of the novated lease arrangement you are entering into with the debt you are getting into.

If you would like to find out how much a novated lease can benefit you, check out our salary sacrifice novated lease calculator .