Explainer: Are you a salaried individual? Know how leave encashment is taxed

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Sick, casual, and paid leaves are typically separated into these three categories among salaried workers in the employed population. Employees can use their outstanding leave balance or quota when they retire or quit their jobs, thus taking advantage of these accumulated leaves is not compulsory. The guidelines and the leave encashment policy vary from one firm to the next. Although the general thumb rule is that leave balances can be redeemed at the time of retirement or resignation, company policies regarding the complete and final settlement of leave encashment might differ. However, any leave taken while employment is entirely taxed. Nonetheless, under Section 89 of the Income Tax Act, one may request a leave encashment exemption. For employees of the Central or State Government sector, any leave encashment granted at the time of retirement or resignation is completely exempted. Additionally, non-government employees who get leave encashment are partially exempt. Let’s know in brief from industry experts how and when leave encashment is taxable.

Comments by CA Manish P. Hingar, Founder at Fintoo

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. Let’s understand the tax impact of leave encashment:

Taxation of Leave Encashment

Leave encashment received during service

1. Accumulated leave can either be encashed during service or at the time of retirement or resignation.

2. Any leave encashed during service is fully taxable and forms part of ‘income from Salary’. However, relief under Section 89 can be claimed.

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:

1. Leave encashment received by Central or State Government employees at the time of retirement or resignation is fully exempt.

2. Leave encashment received by legal heirs of deceased employees is fully exempt.

3. Leave encashment received by Non-Government employees 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:

Sr No. Particulars Amount
(A) Leave encashment received XXXXX
(B) Less: Exemption under Section 10(10AA) –Least of the following:  
(C) Amount notified by the Government Rs** 3,00,000 3,00,000
(D) Actual leave encashment amount XXXX
(E) Average salary* of last 10 months XXXX
(F) Salary per day * unutilised leave (considering maximum 30 days leave per year) for every year of completed service XXXX
  Leave encashment taxable – (A) – (B) XXXX

Salary for this purpose includes basic salary, dearness allowance and commission based on a fixed percentage of turnover secured by the employee. Specified amount of 3,00,000 is the aggregate amount allowed as exemption irrespective of frequency of leave encashment received by employees by various employers. If an employee has utilised 2,00,000 already at the time of first resignation, he is only entitled to use the balance of 1,00,000 for the exemption computation next time. Hence, an overall employee is allowed total exemption of only 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 33,000 per month at the time of retirement and received 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 * 1,100)
Less : exempt 2,75,000

Least of the following:

1. Amount notified by the Government

2. Actual leave encashment

3. Average salary for 10 months – 33,000 * 10 months

4. 1,100 * (30 days * 15 completed year of service minus 200 days of utilised leave)

 

3,00,000

3,76,750

3,30,000

2,75,000

Leave encashment taxable as ‘Income from salary’ 1,01,750

Comments by Dr. Suresh Surana, Founder, RSM India

Leave encashment refers to any cash received by the employees towards unutilized/credited leaves both during the tenure of their service as well as at the time of retirement. Leave encashment received by the Government employees at the time of retirement/ superannuation would be exempt from tax u/s 10(10AA) of the Income-Tax Act (hereinafter referred to as IT Act). On the other hand, employees other than Government employees receiving Leave Encashment may also avail tax exemption of section 10(10AA) of IT Act to an extent of lower of the following-

i. Actual Amount Received; or

ii. Rs.3,00,000; or

iii. 10 months Average salary; or

iv. Unavailed Leaves*Average salary

It is pertinent to note that any leave encashment received during the tenure of service or period shall be taxable for all employees.

For the purpose of the above computation, Average salary would mean average of 10 months’ salary preceding the date of retirement and Salary would constitute Basic salary, Dearness allowance (in terms) and Commission based on a fixed percentage of turnover secured by an employee.

Leave Credit would mean Leaves Allowed reduced by Leaves Availed. IT Act Allows 30 Leaves for each completed year of service.

Comments by Sandeep Setty, Vice President of HR, Pazcare

Leave encashment is simply the amount of money obtained in exchange for the period of leaves not availed by an employee. In my previous experience, earned leave encashment was calculated based on basic salary, and was encashed during employee exit only. However, there are companies that calculate it based on gross salary.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint.

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