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December 1, 2020

Know tax exemption when you received accumulated leave balance

by CA Shivam Jaiswal in Income Tax

Know tax exemption when you received accumulated leave balance

During the tenure of their service, one is allowed to avail several leaves such as sick leaves, casual leaves, public holidays, religious holidays, maternity leaves, leaves without pay and so on. 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 unutilized paid leaves.

If the employee does not avail the earned leaves during the specified period allowed to him/her, such leaves may get lapsed, or they may be accumulated or cashed in the subsequent period based on the service rules in force. Encashment of leaves against the leaves no availed by the employees is known as leave salary. We shall learn the tax implications of leave salary in this article.

Tax implications of leave encashment received during service

Accumulated leave can either be encashed during service or at the time of retirement or resignation. Proceeds received towards leave encashment are taxable if received while in service and forms part of ‘income from Salary’. However, a relief under Section 89 can be claimed.

What relief is available in leave encashment?

  • Section 89(1) provides for relief to an assessee when salary, etc., is paid in arrears or in advance or if he receives in one financial year salary for more than 12 months or a payment which under the provisions of section 17(3) is a profit in lieu of salary and therefore, his income is assessed at a rate higher than at which it would have otherwise been assessed.
  • This relief is granted by the Income-tax Officer on an application made to him in this behalf.
  • The question of admissibility of relief under section 89(1) in respect of amounts received on encashment of leave salary while in service was considered by CBDT. 
  • CBDT advised that relief under section 89(1) read with rule 21A of the Income-tax Rules would be admissible in respect of encashment of leave salary by an employee when in service. 

Tax implications of leave encashment 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:

  • 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’

Computation exempt leave salary in case of Non-Government employees

In case of any other employee, least of the following shall be exempt:

  • Actual amount received
  • 3,00,000
  • 10 months Average Salary
  • Average Salary x leaves at the credit of an employee (leaves cannot exceed 30 days for every completed year of service

Note

Average Salary = Average of salary drawn in the last 10 months immediately preceding the date of retirement.

Salary includes basic pay, dearness allowance to the extent it forms part of retirement benefits and percentage wise fixed commission on turnover.

If leave encashment is received by an employee from more than one employer in the same previous year or in different previous years the aggregate maximum amount exempt from tax on account of leave salary cannot exceed 3,00,000.

If the employee had received leave encashment in any one or more earlier PY and had availed of the exemption in respect of such amount, then the limit specified above shall be reduced by the amount of exemption availed earlier

Let us refer to the examples given below to understand this better:

Example 1:

For instance, Mr A is a private sector employee, who worked for 25 years and is eligible for 45 earned leaves per year or 1,125 leaves over 25 years, and earned a monthly salary of Rs. 25,000. He used 585 leaves over the service period, which means he can encash 540 leaves (1125 – 585) or 18 months of the leaves, but he received Rs. 6 lakh as leave encashment at the time of leaving the company.

However, since the rule of encashing a maximum of 30 days for each completed year of service applies, his earned leave eligibility is 30 days multiplied by 25 or 750 days. Since he already utilized 585 days of leave, he is eligible to encash only 165 days (750 – 585) or 5.5 months of leave.

Here, the cash equivalent will be 5.5 months multiplied by Rs. 25,000 or Rs. 1,37,500. The tax exemption will be the minimum of:

  • The amount received as leave encashment (Rs. 6 lakh)
  • The maximum cap as stated by the government (Rs. 3 lakh)
  • The last 10 months’ average basic salary and DA (Rs. 25,000 * 10 or Rs. 2.5 lakh)
  • Cash equivalent of the leave balance, subject to a maximum of 30 days for each completed year of service Rs. 1,37,500.

The least amount here is Rs. 1,37,500. The remaining amount will be taxable. In this case, the taxable amount will be Rs. 6 lakh – Rs. 1,37,500 or Rs. 4,62,500. 

Example 2:

Mr B is a government employee and he is entitled to 30 days leave per year. His outstanding earned leaves are 350. He received Rs. 10,00,000 on account of leave encashment at the time of retirement.

Mr. B is a Government employee and amount received of Rs. 10,00,000 on his retirement is fully tax free.

Sometimes the employees can not avail all these earned leaves which were allowed to him. He may encash these leaves and earn salary for the number of days which were allowed to be taken as leaves. The number of leaves allowed to be taken and the leave encashment varies from employer to employer policies. It is important to know the tax implications of leave encashment, so that they do not miss out on their earned benefits.

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