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Leave Encashment: Tax Exemption under 10(10AA), Calculations

Updated on: 16 Jan, 2024 05:49 PM

Sick leave, casual leave, annual leave 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 employer. Many businesses and organizations allow you to carry forward your leaves for an indefinite period.

Leave encashment refers to converting unused or accumulated leave days into cash or a monetary benefit. It is a policy that allows employees to receive compensation for the unused portion of their earned leave when they leave employment or as per the rules of their organization.

This guide will discuss the tax implication on the money received in lieu of leaves.

Budget 2023 update: The leave encashment tax exemption limit for non-government employees was Rs.3 lakh since 2022 and is now increased to Rs.25 lakh owing to the general increase in income from salary.

What is Leave Encashment?

"Leave encashment" refers to compensation or payment made in return for unused leaves. Employees can encash their accumulated leave at any moment during their employment, or while retiring or continuing to work, while leaving the organization, or as per the organization's policy. Private organizations mostly depend on the employer, as some organizations 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 unused paid leaves.

What are the types of Leaves?

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 carried forward as per company’s policy.
2. Privilege Leave The employee can get this leave by providing prior information about the leave to the employer. The leave is paid and is sanctioned by the employer. If the employee does not avail of this leave, they can accumulate and encash them later. However, each organization has its own set of regulations regarding privileged leave and its encashment.
3. Medical Leave The employee can avail of this leave if they are sick and cannot work in normal conditions. They have to inform the employer to avail leave. The number of medical leaves granted to the employee depends on each organization; such leaves are paid. As this leave is a kind of emergency leave, no prior information is mandatory before the leave from the employee to the employer. At the same time, the employee has to provide a valid medical certificate to the employer if they have taken it for a longer period of time. This cannot be considered for leave encashment.
4. Maternity Leave It is provided to pregnant female employees during their employment period. The leave is paid from 12 weeks up to 26 weeks of pregnancy. The employer also gives a Longer extension period until the next 16 months, but that leave period is unpaid. Deductions are not made from the leave salary account during the leave period. This cannot be considered for leave encashment
5. Quarantine Leave If there is an outcome of any infectious disease in the family or the neighbourhood of any employee, the employee can avail of quarantine leave. Granting this leave can prevent other employees from getting infected by the disease. This cannot be considered for leave encashment.
6. Sabbatical Leave This leave is granted to employees willing to expand their knowledge by adopting various relevant institutional courses. They can adopt for any specialized training or workshop relevant to their working field and can also take university admissions 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 employees who become fathers. However, only government employees may avail of paternal leave benefits 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 employees working in government organizations. Once employees complete their one year in the organization, they can avail of half-pay leaves as and when required. In this leave, the employee receives a half day's salary during their leave period. The inclusion of these during leave encashment depends upon the government. organization

Providing such leaves has multiple benefits for employees and the organization.

  • In case of any medical emergency or health conditions, employees can avail of medical leaves, which are extendable.
  • Maternity and paternity leaves are very important and useful for working women during pregnancy.
  • Holidays are the perfect leaves when 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 many benefits from the study leaves as employees trained with new skills and knowledge add more value to the organization, thus improving business growth.
  • Paid leave is granted by the organization so that employees can balance their work-life and create 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, generosity by giving their best working performance.

What is the process of Leave Encashment?

Salaried government and private sector employees 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 employees throughout their employment and after retirement.

The employer also offers employees incentives and allowances like travel, food, and accommodation during their employment period. The organization provides insurance policies for the employees to claim 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.

Taxation of Leave Encashment

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.

To get tax relief for leave encashment, the employee should fill out form 10E. This form is available on the e-portal of the income tax department and, once filled, can be submitted online.

Leave Encashment After retirement or resignation

At the time of retirement or resignation; the employee can avail of encashment through their accumulated paid leave. However, various conditions depend upon the type of organization 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, 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. The maximum tax exemption amount was Rs 3,00,000, increased to INR 25,00,000 in the New finance budget 2023 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 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 the employee (other than mentioned above) shall be exempt up to 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 considered is based on salary received during the 10 months preceding their retirement or resignation

Note 1:- Even if the Non-Govt. the employee has accumulated a number of leaves in a year, As per the Provision Of Income tax act, the department will consider only a maximum of 30 days of leave for a year for the Calculation of exempted amount. 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.

Note 2:- 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 3:- In case of resignation or termination, 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 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.

How is leave encashment calculated?

Leave encashment received by govt employees is tax-free. leave encashment received by private employees are a minimum of the following:

  1. Amount received as leave encashment
  2. The maximum amount stated by the government, i.e., 25,00,000
  3. last 10 months of basic salary and DA
  4. Salary per day*unutilised leave (consider a maximum of 30 days leave per year) for every year of completed service

Example of the Leave Encashments

To make it easier to understand, here is an illustration:
Mohan has retired from the organization 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 a basic salary + D.A. INR 30000 per month at retirement. He received a leave encashment of INR 365000 (365*1000).
Taxable leave encashment will be the Actual amount received: INR 365000
Exemption under section 10(10AA):- Least of A, B (i, ii & iii)
i) Average Salary of 10 months: 3,00,000
ii) 30 leaves per year allowed (30*20-actual leave taken)*1000 = 6,00,000
iii) Maximum Allowed: 25,00,000

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.

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).

If you're unsure about the tax implications of your leave encashment or if you're facing difficulties in claiming the tax properly, it's recommended to seek professional advice. Tax experts at Tax2win let you claim deductions, maximize your savings, and ensure a smooth filing.

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Frequently Asked Questions

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 if it is received on resignation

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 a maximum of INR 25 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- 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. 25,00,000
  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 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.