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Leave Encashment & Its Tax Implications Under Section 10(10AA)

Updated on: 03 Aug, 2022 06:09 PM

Sick leave, casual leave, yearly or earned leave, and other types of leave are available to salaried employees. Some of these paid leaves can be carried over to the next year, depending on the rules set by the company. Many businesses and organizations let you to carry forward your leaves for indefinite amount of time. W hen you resign or retire, you can take money by giving the leave days back to the company. As a result, you will be compensated for all of the leave that you did not take. This is referred to as "leave encashment." In this guide, we will talk about the tax implication on the money received in lieu of leaves.

Important: e-verify your income tax return within 30 days, else your return will be considered as not filed.

What is the process of Leave Encashment?

Salaried employees working in government and private sector, however, get nearly equal work benefits regarding their pay scale, tax deductions and leaves. The employee is subjected to pay income tax if their annual income exceeds the limit as advised by the income tax department. The employer deducts some amount from the employee’s salary account and deposits that amount in the provident fund (PF) account. The provident funds are accessible for the employee throughout their employment period and after retirement. The employer also offers incentives and allowances like travel, food, accommodation for the employee during their employment period. There are insurance policies provided by the organization for the employees through which they can claim them during health emergencies and use the matured amount after retirement. However, an employee can carry forward their leaves if not used in the year and can later ask for encashment on behalf of the leaves untaken. This process is known as leave encashment and every employee can get its benefits.


What is Leave Encashment?

The term "leave encashment" refers to compensation or payment made in return for unused leaves. Employees can cash in their accumulated leave at any moment during their employment, including when they retire, continue to work, or quit. In private organizations, it mostly depends on the employer as some firms reimburse employees for unused leaves in the next calendar year. On the other hand, some employers allow employees to carry over their unused vacation time from one year to the next. At the time of leaving the job, the company pays for any untaken leaves.


What are the different types of Leaves and Leave Encashment?

The leaves provided are categorized as paid and unpaid leaves.

Types of Leaves Description
1. Casual Leave This type of leave is most commonly availed by the employee. This leave can be taken for a maximum of seven days. However, it depends on the guidelines provided by the employer for each organization may vary. The employee has to inform the employer about the casual leave to be taken beforehand and mention the number of days or duration of the leave. It will be considered for leave encashment if it is allowed to be carriedard as per company’s policy.
2. Privilege Leave The employee can get this leave by providing prior information about the leave towards the employer. The leave is paid and is sanctioned by the employer. If this leave is not availed by the employee they can further accumulate them and encash them later. However, each organization has its own set of regulations regarding privilege leave and its encashment.
3. Medical Leave The employee can avail this leave if they are ill and are not able to work in normal conditions. They have to inform the employer for avail leave. The number of medical leaves granted to the employee depends on each organization and such leaves are paid leaves. As this leave is a kind of emergency leave, no prior information is mandatory before the leave from employee to the employer. Whereas the employee has to provide a valid medical certificate to the employer if leave is taken for a longer period of time. This cannot be considered for leave encashment.
4. Maternity Leave It is provided to female employees who are pregnant during their employment period. The leave is paid for the period from 12 weeks up to 26 weeks of pregnancy. A Longer extension period is also given by the employer until the next 16 months but that leave period is unpaid. During the leave period, deductions are not made from the leave salary account. This cannot be considered for leave encashment
5. Quarantine Leave If there is an outcome of any infectious disease in the family or in the neighbourhood of any employee, the employee can avail of quarantine leave. Granting this leave can prevent other employees from getting infected from the disease. This cannot be considered for leave encashment.
6. Sabbatical Leave This leave is granted for the employees willing to expand their knowledge by adopting for various relevant institutional courses. They can adopt for any specialized training or workshop which is relevant to their working field and can also take admissions to universities for long term courses. These leaves are paid for a period of time as decided by the organization. This cannot be considered for leave encashment.
7. Paternity Leave This leave is especially available for the employees who become fathers. However, only government employees may avail the benefits of paternal leave in India. The parent employee can be granted 15 days of leave before or after the birth of a child. The leave can also be availed up to 6 months from the child’s birth.This cannot be considered for leave encashment.
8. Holidays Holiday leaves are paid leaves and there is no deduction from the salary account of the employees. Holidays include national holidays, festivals and weekly off. Employees working in all sectors enjoy these holiday leaves. These are considered for leave encashment.
9. Half pay Leave This leave can be availed only by the employees working in government organizations. Once the employee completes their one year in the organization they can avail half pay leaves as and when required. In this leave, the employee receives a half day salary during their leave period. The inclusion of these during leave encashment depends upon the govt. organisation

Providing such leaves has multiple benefits for employees as well as for the organization.

  • In case of any medical emergency or health conditions employees can avail medical leaves which are extendable.
  • Maternity and paternity leaves are very important and useful working women during their pregnancy.
  • Holidays are the perfect leaves where employees can enjoy festivals and their time with their loved ones.
  • Availing sabbatical or study leaves can really help employees to advance their knowledge levels and skills further adding more flexibility and confidence while working.
  • Organizations get a lot of benefit from the study leaves as employees trained with new skills and knowledge add more to the organization thus improving business.
  • Paid leave granted by the organization lets employees balance their work-life and creates a sense of trust while working with the organization. Perhaps organizations have to take care of their employees in all conditions and employees should in return the generosity by giving their best working performance.

Labour Act: A Guideline for Employers and Employees

Every organization provides working guidelines to its employees based on the regulations of labour law. The labour law lays regulations regarding the terms and conditions of employment, discrimination, employment leave rights, employee representation and employee privacy rights. All organizations working in India should comply with these regulations and provide guidelines to their employees. The regulations set by the Labour Act ease the recruitment process of an employee, their agreements with the organization, basic pay scale provided as per minimum wages and other employee protection guidelines. Rights regarding leaves for the employee taken during the employment duration should comply with the Labour Act. Therefore organizations should always follow regulations provided in order to secure employee rights.


Leave Encashment and Tax

Leave Encashment During the employment period

Any employee demanding leave encashment for their unused paid leave during their employment period is taxable as it is considered as income from salary. In this case, the employee can get tax relief under Section 89. As per Section 89, the employee can claim tax relief from the amount received through the leave encashment process. In order to get tax relief for leave encashment, the employee should fill form 10E. This form is available on the e-portal of the income tax department and once filled can be submitted online. The only tax paid during the encashment will be income tax from salary.

Leave Encashment After retirement or resignation

At the time of retirement or resignation, the employee can avail encashment through their accumulated paid leave. However, there are various conditions depending upon the type of organisation in which the employee has worked.

  • When the employee has worked in the central or state government organization, they can fully claim for their paid leave encashment and that too with full exemption from tax.
  • In the case of an employee's death before the leave encashment, their legal heirs can receive total leave encashment on behalf of the deceased. No income tax will be charged on the amount received by them.

Employees working in the private sector can receive paid leave encashment at the time of retirement or resignation.Maximum tax exemption amount is Rs 3, 00,000 for the leave encashment otherwise the amount exceeding this value is taxable. The calculation of exempt leave encashment is as per section 10(10AA)


What is Income Tax Exemption Under Section 10(10AA)?

Taxability and exemption related to leave encashment can be understood as:-

  • Any Amount Received as Leave Encashment during employment then the amount received will totally be taxable in all forms. But according to Section 89, Income Tax Act, the employee can claim for tax relief from their leave encashment amount.
  • Any Amount Received as Leave Encashment at the time of retirement then
    Any Leave Encashment amount received by an employee of the Central Government or a State Government shall be fully exempt.
    Any Leave Encashment amount received by employee (other than mentioned above) shall be exempt upto a certain amount i.e,The average salary of 10 months. The salary includes basic salary and dearness allowances. Also, the commission received is considered. The salary of 10 months actually considered is on the basis of salary received during the 10 months preceding their retirement or resignation

Note 1:- Even if the employee has accumulated a number accumulated number of leaves in a year, the organization will consider only a maximum of 30 days of leave a year for the encashment process. According to it, the total number of paid leaves will be calculated altogether during the retirement or resignation and then encashment will be processed further. Suppose a person has not utilized all the paid leaves and it accounts for 45 days still the organization will only consider 30 days of paid leave for encashment at the time of resignation or retirement.

Note 2:- For employees who have retired after 1998, their leave encashment amount is subjected to a maximum limit of Rs. 3, 00,000 to be received which is specified by the government. When the actual amount to be received will be more than Rs. 3, 00,000, then 3, 00,000 will be received as the encashment amount and the remaining amount will be received in the salary account which will be taxable.

Note 3:- The legal heirs of deceased employees at the time of leave encashment can receive the amount without any form of tax deduction from the amount.

Note 4:- In case of resignation or termination, both government and non-government employees are held to pay the tax on the amount received from paid leave encashment because the amount at the time is considered as income from salary by the income tax department. The rate of tax to be paid is applied the same as during income tax on salary.


Example of the Leave Encashments

To make it easier to understand, here is an illustration:
Mohan has retired from the organisation after serving for a period of 20 years. He was entitled to 32 days of paid leave in a year.But he exhausted 275 leaves and left with 365 days of leave.He draws basic salary + D.A INR 30000 per month at the time of retirement. He received leave encashment of INR 365000 (365*1000).

Taxable leave encashment will be:

Actual amount received : INR 365000
Exemption under section 10(10AA):- Least of A , B (i, ii & iii) -
i) Average Salary of 10 months: 300000
ii) 30 leaves per year allowed (30*20-actual leave taken)*1000 = 325000
iii) Maximum Allowed: 300000

So, Lower of all is exempt i.e. INR 300000
Therefore, taxable leave encashment will be 65000(365000-300000)


Leave Encashment and Tax Implications in a Nutshell

If you cash in your leave while still employed by the company/government organization, the money is liable to tax without exception.
Employees of the government, whether they work for the federal government or the state government, are not required to pay any tax on leave encashment income when they retire or quit.
Employees in the private sector who receive leave encashment after retirement or resignation are subject to 'Income from Salary' taxation. However, some exemptions apply to this income. The remaining amount will be added to the normal income and taxed according to the income tax slabs after the exemption has been taken into account.
Section 10 of the Internal Revenue Code exempts private sector employees from paying taxes on their leave encashment income (10AA).


Conclusion

Hence, leave encashment process is totally transparent and easy to avail by employees during or after their employment period. The government of India has provided the Labour Act according to which the employees should get equal rights, leaves and wages. The leave encashment policy works the same for every employee. This encashment amount can further be useful for important things like healthcare, education of their children and personal savings. Considering the cost of inflation the leave encashment can be received during the employment period or after retirement. The employee can decide whether to receive a one-time amount or in stages. When the amount is large, employees should plan their tax returns accordingly.


Frequently Asked Questions

Q- How leave encashment is calculated?

Leave encashment received by govt employees are tax free. leave encashment received by private employees are minimum of the following:
1. Amount received as leave encashment
2. Maximum amount stated by government i.e. 300000
3. last 10 months of basic salary and DA
4. Salary per day*unutilised leave (consider maximum 30 days leave per year) for every year of completed service


Q- Can Leave encashment be withheld?

Leave encashment can be withheld if the assessee faces a criminal case or any departmental proceedings at the time of retirement.


Q- Is leave encashment taxable on resignation?

Leave encashment is taxable whether it is received on retirement or resignation for private employees.


Q- What is leave encashment?

Leave encashment refers to the monetization of unavailed leave which is carried forward.


Q- What is provision for leave encashment?

The provision of leave encashment is that maximum of INR 3 lakh is exempt from and for govt employees it is fully tax free.


Q- How many leaves can be encashed?

Leaves earned by the employees can be encashed in the next year, the quantum of leaves encashed is not more than 50% of earned leaves at credit or 30 days earned leave whichever is less.


Q- Can casual leave be encashed?

It depends upon the policy of your company. If CL is paid on certain days then it can be encashed.


Q- Is leave encashment taxable for bank employees?

Yes leave encashment is taxable for the bank employees subject to certain conditions


Q- Is leave encashment a perquisite?

The number of leaves an employee can avail and the leave encashment allowed are dependent on the employer. The amount received as leave encashment is a perquisite to the employee and the tax implications are dependent on whether the leaves are encashed during the course of employment or at the time of retirement.


Q- How does the gratuity benefit work for the employees?

Gratuity is a benefit given by the employer to employees. As per recent amendment, Receipt of Gratuity is exempt up to Rs 20 lakh from the previous ceiling of Rs 10 lakh, which comes under Section 10(10) of the Income Tax Act.


Q- Is leave encashment taxable on resignation?

Leave encashment is taxable on resignation for a non-government employee based on calculation as per section 10(10AA).For a government employee, leave encashment received after retirement or resignation is exempt from tax.


Q- What is the leave encashment formula?

Leave encashment for non-government employee can be calculated as :

  1. Actual amount received.
  2. Average Salary of 10 months
  3. 3,00,000
  4. Salary per day*unutilised leave (consider maximum 30 days leave per year) for every year of completed service, Whichever is lower is exempt.

CA Abhishek Soni
CA Abhishek Soni

Abhishek Soni is a Chartered Accountant by profession & entrepreneur by passion. He is the co-founder & CEO of Tax2Win.in. Tax2win is amongst the top 25 emerging startups of Asia and authorized ERI by the Income Tax Department. In the past, he worked in EY and comes with wide industry experience from telecom, retail to manufacturing to entertainment where he has handled various national and international assignments.

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