A new prime mover, excavator or fleet of utes can cost more upfront to purchase than a business wants to pull out of its working capital. The main alternative to buying outright is leasing, which still gets the asset working for you straight away without the outlay.
Australian businesses have two main options here: finance leases and operating leases. Both give you access to the vehicle or equipment you need, but they suit different business models and preferences.
Operating leases vs finance leases: explained
| Operating lease | Finance lease | |
|---|---|---|
| Ownership | Sits with the lessor at all times | Sits with the lessor during the term, transferring to your business once the residual is paid |
| Business use requirement | At least 51% | At least 51% |
| Residual payment | You don't pay one | You pay it at the end of the term |
| Residual value risk | Sits with the lessor | Sits with your business |
| Lease terms | One to five years | One to five years |
| Eligible assets | Vehicles and standardised equipment with a reliable resale market | Vehicles, machinery, plant and specialised equipment |
| Running costs | Can be included (fully maintained) or excluded (non-maintained) | Can be included (fully maintained) or excluded (non-maintained) |
| Return conditions | Asset must meet criteria, including kilometre limits and fair wear and tear standards | N/A |
| Options at end of lease | Return the asset, extend the lease or replace the asset with a new one on a new lease | Buy the asset, sell it, trade it in or refinance the residual and extend |
| Tax deductions | Lease payments and running costs, subject to your business use | Lease payments and running costs, subject to your business use |
| Available terms, eligible assets and conditions vary between finance providers. | ||
What is an operating lease?
An operating lease works like a long-term rental. The lessor buys the asset, hires it to your business for an agreed term, and takes it back at the end. You never take ownership, and there's no residual to pay out.
Because you're paying for the use of the asset over the term rather than its full value, rentals on a non-maintained operating lease are often lower than the equivalent finance lease. That makes them a fit for businesses that refresh vehicles or equipment on a cycle and would rather not deal with resale.
Operating leases are most common on road vehicles but are also available on equipment with a reliable secondary market. Specialised or purpose-built assets are harder to place, because the lessor has to be confident it can sell the asset when it comes back.
The conditions you'll have to meet to return your leased asset
Because the lessor is relying on the asset holding its value, your agreement will set conditions on how you use it and what condition it comes back in. Common ones include:
- Kilometre limits: your rentals are priced against an agreed annual or total kilometre allowance. Going over it is charged at a set rate per excess kilometre, so it pays to be realistic about your usage upfront rather than choosing the cheapest quote.
- Fair wear and tear: minor scratches, stone chips and interior marks consistent with normal business use are accepted. Panel damage, cracked glass, torn upholstery, worn tyres below the legal tread depth and missing accessories are generally charged back to you.
- Servicing and maintenance: on a non-maintained lease you'll need to keep the asset serviced to the manufacturer's schedule and hold the records to prove it.
- Modifications: signage, racks, tow bars and other fit outs usually need to be removed and any damage repaired before return.
Most lessors inspect the asset at the end of the term and issue a report covering anything outside those standards. Ask for the return condition guidelines before you sign, since they vary between lenders and are easier to plan around than argue about later.
What is a finance lease?
Like an operating lease, your lessor buys the asset and hires it to your business for an agreed term on a finance lease. The difference is that it comes with a residual you have to settle at the end of the term, which you can do by either paying it out and keeping the asset or selling or trading it in.
You're responsible for the asset's condition, and if it's worth less than the residual when the term ends, that shortfall is yours to wear. In exchange, there are no kilometre limits or return conditions to meet, so you can often modify the asset as your business needs.
The cost of your lease is calculated on the value of the asset, the length of the term, the residual and the lessor's rate and fees. Finance leases cover a wider range of assets than operating leases, including machinery, plant and specialised equipment, because the lessor doesn't need to resell the asset to recover its position.
How finance leases are classified
Your lessor determines whether a lease is a finance or operating agreement under AASB 16, the Australian equivalent of IFRS 16. It’ll generally be classified as a finance lease where:
- Ownership transfers: the agreement hands the asset to your business by the end of the term.
- There's a bargain purchase option: you can buy the asset for less than its expected market value, making it near certain you'll take it up.
- The payments cover most of the value: the present value of your lease payments accounts for substantially all of the asset's fair value at the start of the lease.
- The term covers most of the asset's life: the lease runs for the majority of the period the asset is useful.
- The asset is specialised: only your business could use it without significant modification.
Finance vs operating lease residuals
A residual is the value the lessor assigns to the asset at the end of the term. They’re applicable on both operating and finance leases, but they’re treated differently.
On a finance lease, the residual is your obligation. You can settle it by paying it out and keeping the asset, or by selling or trading in the asset and putting the proceeds towards it. If the sale falls short, you’ll have to pay the difference, but you can pocket any profit you may make. Some lessors will also let you refinance the residual to extend the lease, rather than settle it outright.
On an operating lease, you hand the asset back and the residual is the lessor's problem. If it's worth less than they estimated, they wear the loss.
How much will my residual be?
The ATO sets minimum residual values so that a lease is treated as a genuine lease rather than a disguised purchase. The percentages depend on the asset's effective life and the total time it's leased for, and are calculated using the following formula:
75% – [(75% ÷ effective life) × total leased period]
For example, cars have an effective life of eight years, which produces the following minimums:
| Lease term | Minimum residual value |
|---|---|
| 12 months | 65.63% of purchase price |
| 24 months | 56.25% of purchase price |
| 36 months | 46.88% of purchase price |
| 48 months | 37.50% of purchase price |
| 60 months | 28.13% of purchase price |
On a $60,000 ute, that's a minimum residual of $28,128 over three years, or $16,878 over five. Assets with a different effective life produce different figures, so a piece of machinery won't follow the table above. Your lessor can choose to set a higher residual, which would mean your payments are lower but the amount you have to cover at the end is greater.
If you re-lease the same asset, the percentage is worked out on the total period it's been leased and on its cost at the start of that period, so extending doesn't reset the clock.
Case study: taking out a finance lease for equipment
Priya runs an earthmoving business in regional Victoria and needs a second excavator to take on a council drainage contract. The machine she wants costs $180,000, and she expects to keep it for at least a decade.
She takes out a five-year finance lease. Her lessor sets a residual of $50,000 (30% of the purchase price), which she'll pay out at the end to own the machine outright. The lease suits her because the excavator holds its value in her industry and she has no intention of handing it back. There are also no usage limits to work around, so she can run the machine as hard as the contract demands and fit the attachments she needs without seeking approval.
When the term ends, Priya pays the residual and keeps the excavator. It runs for another six years with no finance costs attached, which is where the arrangement pays off for her.
Case study: managing a fleet of cars with operating leases
Dean runs a building inspection company in Brisbane with six inspectors on the road. Each one needs a reliable vehicle and Dean doesn't want to be in the business of selling used cars every few years. He puts the fleet on three-year operating leases with an annual allowance of 30,000km per vehicle. Because he's leasing rather than buying, there's no upfront outlay and his monthly cost is fixed and easy to budget against.
At the end of the three years, the cars are returned to the leasing company. Dean has no residual to settle and no stake in what the vehicles are worth, so he signs a new set of leases and his inspectors move into new cars. The trade-off is that Dean never owns anything. He also has to keep the vehicles serviced on schedule and within the kilometre allowance or he'll be charged for the excess when they're sent back.
Fully maintained leases vs non-maintained leases: explained
When you take out your commercial lease, whether finance or operating, you can choose between a fully maintained lease and a non-maintained lease. Here’s how each one works:
Fully maintained lease
Fully maintained leases have your on-road costs included in your payments. They’re organised by your leasing company on your behalf, so you won’t have to worry about managing these expenses yourself. Some of the common inclusions for fully maintained car leases are:
- Comprehensive insurance
- Fuel
- Roadside assistance
- Servicing and maintenance
- Tyre replacement
- Vehicle registration
The big benefit of going down this road is that you’ll save yourself time and effort by outsourcing the admin related to running your asset. However, your provider may price a margin into your running costs.
Non-maintained lease
On the other hand, opting for a non-maintained lease means you’ll be managing these costs yourself. You’ll be required to spend more time doing this, but your payments themselves will be cheaper (though you’ll still have to cover all the same costs yourself). You might also be able to save money by having a greater say in things like your insurance policy and maintenance, as well as only paying for the petrol you need.
Finance and operating lease tax treatment
Under both lease types, the lessor owns the asset, which shapes what your business can and can't claim. Here’s what you can expect from your lease agreement:
What you can claim
- Lease payments: deductible to the extent the asset is used for business. If you use your leased car for private purposes 30% of the time, you can only claim up to 70% of your payment.
- Running costs: deductible on the same basis, whether bundled into a fully maintained lease or paid separately.
- GST credits: claimable on the GST included in your lease payments and on-road costs as you pay them, provided your business is registered for GST.
What you can't claim
- Depreciation: unavailable to businesses who don’t own the asset in question.
- The instant asset write-off: only available on assets your business holds, so a lease rules it out.
- Interest: not deductible separately, as your lease payment is claimed as a whole rather than being split into principal and interest.
If you end up purchasing the asset at the end of a finance lease, you’ll be able to claim things like depreciation and GST on the residual. However, it’s worth speaking to your accountant about what you can and can’t claim.
How AASB 16 affects your accounts
AASB 16 changed how leases appear in financial statements in 2019. Since the change, businesses reporting under Australian Accounting Standards bring almost all leases onto the balance sheet as a right-of-use asset and a matching liability, regardless of whether the lease is finance or operating.
That means the old advantage of operating leases keeping debt off your balance sheet no longer applies to those businesses. Short-term leases of 12 months or less and low-value assets are the main exceptions.
AASB 16 is an accounting change, not a tax one, so your deductions work the same way. The depreciation and interest recognised in your accounts under AASB 16 aren't what you claim on your return.
The standard only applies to businesses preparing general purpose financial statements. Many small businesses don't, in which case it makes no practical difference to how you compare the two products.
Finance and operating leases vs chattel mortgages
A chattel mortgage is the main alternative to leasing. Your business buys the asset outright with borrowed funds, meaning you own it from day one. Your lender takes security over it until the loan is repaid. This can apply to vehicles, business equipment and other eligible commercial assets.
Here are the main differences between the finance types:
| Finance lease | Operating lease | Chattel mortgage | |
|---|---|---|---|
| Ownership | Lessor, then lessee | Lessor | Your business |
| Claimable depreciation | No | No | Yes |
| Claimable interest | No | No | Yes |
| Claim payments | Yes, in full | Yes, in full | No, only the interest portion |
| Instant asset write-off | Not available | Not available | Available, subject to eligibility |
| GST credits | Claimed on payments over the term | Claimed on payments over the term | Claimed upfront on the purchase price |
| Balloon or residual | Required | Not payable by lessee | Optional |
On a chattel mortgage, you can claim the full GST credit on the purchase price in the BAS period the asset is bought, which can be a substantial cash injection. On a lease, this is claimed gradually as you pay.
A chattel mortgage tends to suit businesses that want to keep the asset long term and can use the depreciation and write-off benefits. Leasing suits businesses that would prefer to upgrade on a cycle or preserve cash instead of taking on a loan.
Which lease is best for my business?
Whether an operating or finance lease is best ultimately comes down to the nature of your business and your preferences for running your assets. However, here are some cases where one may be better suited than the other:
When an operating lease might be better
- You upgrade vehicles or equipment on a regular cycle and don't want to be left holding an ageing asset.
- You'd rather not deal with resale or wear the risk of what the asset is worth in a few years.
- Your usage is predictable enough to sit comfortably inside a kilometre allowance.
- You want fixed costs that can be easily budgeted across a fleet.
When a finance lease might be better
- You intend to keep the asset well beyond the term, where owning it outright starts paying off.
- The asset holds its value or is specialised enough that the resale market is thin.
- Your usage is heavy or unpredictable, so return conditions would be difficult to meet.
- You need to modify the asset for the way your business works.
This information is all general, of course, so it's important to speak to your accountant, as they can advise on which product may be best for you. If neither fits, a chattel mortgage might be worth considering, particularly if the depreciation and instant asset write-off benefits would make a difference to your tax position. Additionally, Savvy works with lenders across commercial asset finance, so you can get a free, no-obligation quote with us.
