1. Concept of Leave Encashment
Every salaried person as per labour law is entitled to a minimum number of paid leave every year. However, it is not necessary that an individual employee utilises all the leave he is entitled for a year. In fact, most employers allow the employees an option of carrying forward such unutilised paid leaves. This would invariably leave the employee with an accumulated unutilised leave balance at the time of retirement or resignation from the company as the case may be. This compels the employer to compensate the unutilised paid leave of the employees. This concept is better known as leave encashment.
Now that we have in brief, understood what leave encashment is, the next step is to understand how it is taxed in the hands of the recipient
2. Taxation of Leave Encashment
Leave encashment received during service
Accumulated leave can either be encashed during service or at the time of retirement or resignation. Any leave encashed during service is fully taxable and forms part of ‘income from Salary’. However, a relief under Section 89 can be claimed (refer this circular).
Leave encashed at the time of retirement or resignation
Leave encashment received at the time of either retirement or resignation is either fully or partially exempt depending upon the category that an employee falls under. This has been elaborated further below:
- Leave encashment received by Central or State Government employee at the time of retirement or resignation is fully exempt
- Leave encashment received by legal heirs of deceased employee is fully exempt
- Leave encashment received by Non-Government employee is exempt based on the computation provided under Section 10(10AA)(ii) and balance amount if any is taxable as ‘income from salary’
Formula for computing leave encashment exemption of Non-government employees:
|Leave encashment received (A)||XXXXX|
|Less: Exemption under Section 10(10AA) – (B)
Least of the following:
|Amount notified by the Government**
Rs 3,00,000 (C)
|Actual leave encashment amount (D)||XXXX|
|Average salary* of last 10 months (E)||XXXX|
|Salary per day * unutilised leave (considering maximum 30 days leave per year) for every year of completed service (F)||XXXX|
|Leave encashment taxable – (A) – (B)||XXXX|
*Salary for this purpose includes basic salary, dearness allowance and commission based on fixed percentage of turnover secured by employee
** Specified amount of Rs 3,00,000 is the aggregate amount allowed as exemption irrespective of frequency of leave encashment received by employee by various employers. If an employee has utilised Rs 2,00,000 already at the time of first resignation, he is only entitled to use balance of Rs 1,00,000 for the exemption computation next time. Hence, overall employee is allowed total exemption of only Rs 3,00,000 with respect to leave encashed from all employers.
Let us understand the exemption from an illustration.
Mr A is retiring after 15.5 years of service. Mr A was entitled to 35 days of paid leave per annum from his employer i.e., overall 542 days of leave during his entire service. Out of the same Mr A has already utilised 200 days of paid leave and is left with 342 days of unutilised leave. Mr A was drawing basic salary + DA of Rs 33,000 per month at the time of retirement and received Rs 3,76,750 as leave encashment calculated based on 342 days * Rs. 1,100 (salary per day = Rs.33,000/30 days).
|Particulars||Amount (in Rs)|
|Leave encashment received||3,76,750[342 days * Rs 1,000)|
|Less : exempt||2,75,000|
|Least of the following:
Amount notified by the Government
Actual leave encashment
Average salary for 10 months – Rs 33,000 * 10 months
Rs 1,100 * (30 days * 15 completed year of service minus 200 days of utilised leave)
|Leave encashment taxable as ‘income from salary’||1,01,750|
Based on the employer’s leave encashment policy and income of an individual, tax planning can be made by deciding whether it is beneficial to encash leave year on year or to receive lump sum at the time of retirement or resignation. One may consider cost of inflation as well before deciding on the same.