Novated leases and the deductibility of after-tax running costs
 

Including a car in a salary package is a popular remuneration arrangement, and doing so as part of a salary sacrifice package will often give rise the a “novated lease”.  Costs in operating the vehicle can also be salary sacrificed.  This is typically referred to a fully novated lease.

A novated lease arrangement is a popular way that employers can reward and incentivise employees. Under the right circumstances, employees can reduce their personal tax liability under a salary sacrifice arrangement involving a novated lease.

A novated lease is a three-way deal – between an employee, a financier, and the employer. The employee owns the car, and the employer agrees to make lease repayments to the financier plus pay for any running costs for that car as a condition of employment.

Under such an arrangement, the employer takes over all or part of the lessee’s rights and obligations under the lease of the employee’s car. This transfer of rights and obligations is agreed to in a “deed of novation” between the employer, the finance company and the employee (lessee). The lease obligation typically reverts to the employee upon cessation of their employment.

Under a novated lease, apart from paying for the car lease repayments, the employer would usually pay for the car’s running costs, such as fuel, maintenance, registration and car insurance. For example, some employees are given a fuel card to help pay for petrol.

Is FBT involved?

A car fringe benefit arises under a full novated lease arrangement. The employer is required to determine any FBT liability using the statutory formula method as the default, or alternatively elect to use the log book method.

As FBT is generally borne by the employee as part of their salary package, FBT can be reduced by the employee making after-tax contributions towards the running costs. This is referred to as the employee contributions method.

To reduce the FBT payable on the benefit, the running costs will be paid by the employer company from a combination of an employee’s pre-tax and post-tax income under the salary sacrifice arrangement.

Are after-tax running costs deductible?

A question commonly asked by practitioners is whether the running costs incurred by the employee from their after-tax income are deductible to the employee in their personal return.

And if so, can the employee use one of the two methods prescribed in Division 28 ITAA97 (that is, the cents per kilometre method or the log book method) or otherwise, to claim a deduction for car expenses?

Expense deductions denied

Broadly, “car expenses” incurred by an employee in respect of a car provided by an employer are specifically denied as a deduction under s51AF ITAA36.

In particular, a deduction for “car expenses” is denied where:

  • an employer during a period provides a car for the exclusive use of a person who is, or of persons any of whom is, an employee of the employer or a relative of such an employee, and
  • at any time during that period, the employee or a relative of the employee is entitled to use the car for private purposes.

A “car expense” is defined under s28-13 ITAA97 to include any loss or outgoing to do with a car (including costs in operating the car and its tax depreciation).

Note also that under s51AF ITAA36, the deduction is denied for car expenses that are incurred:

  • during the relevant period in which the car was provided, or
  • is wholly or partly attributed to that period.

Also, as noted, a deduction is not allowed if the car is used by a relative such as a spouse, a parent or a child (see s995-1 for full definition).

In this case, the running costs incurred by an employee from their after-tax income in relation to the car fringe benefit would not be deductible to them due to the operation of s51AF. In other words, they cannot claim a deduction for those costs – whether by using one of the methods in Division 28 ITAA97 or as a general deduction under s8-1 ITAA97.

Section 51AF applies because the vehicle, under the novated lease arrangement, was provided to the employee for her exclusive and private use.

Notwithstanding the above, an employee may still benefit from the arrangement. The after-tax contributions towards the car’s running costs reduce the amount of FBT that they would have been required to salary sacrifice as a component of the total remuneration.