Leave encashment taxation

Leave encashment is a term familiar to many employees, yet its taxation intricacies often raise questions. Whether you are a salaried individual or a business owner, understanding the tax implications of leave encashment is crucial. In this blog, we break down the essentials of leave encashment taxation in India.  

What is Leave Encashment?

Leave encashment refers to the amount paid by an employer to an employee for unused leave days. This can occur during employment or upon retirement/resignation.

Types of Leaves

1. Earned Leave (EL) / Privilege Leave (PL): Paid leave for planned vacations or personal commitments, often encashable.
2. Casual Leave (CL): Short-term leave for emergencies or personal reasons, usually not carried forward.
3. Sick Leave (SL): Leave for medical emergencies or health issues, sometimes requiring a medical certificate.
4. Maternity Leave: Paid leave for childbirth and related care, up to 26 weeks as per law.
5. Paternity Leave: Short leave for fathers during childbirth or adoption, not legally mandated.
6. Bereavement Leave: Leave to mourn the death of an immediate family member.
7. Compensatory Leave: Leave granted for working on holidays or weekends, to be availed later.
8. Study/Examination Leave: Leave for pursuing education or appearing for exams, often unpaid.
9. Leave Without Pay (LWP): Unpaid leave taken when no other leave balance is available.
10. Public Holidays: Designated holidays for national or religious observances, not deducted from leave balance.
11. Sabbatical Leave: Extended leave for personal growth or research, typically unpaid.
12. Special Leave: Leave for specific purposes like marriage, relocation, or volunteering, as per company policy.

Leave Encashment Taxation for Government Employees

For government employees, leave encashment is fully exempt from tax under Section 10(10AA)(i) of the Income Tax Act. This exemption applies regardless of whether the encashment occurs during service, on resignation, or at retirement.

Leave Encashment Taxation for Non-Government or Private sector Employees

Leave encashment taxability for non-government employees depends on whether the encashment occurs during active employment or at the time of retirement, resignation, or termination. Let’s break it down for better understanding.

1. Leave Encashment During Employment

Leave encashment received during active employment is fully taxable. It is treated as part of the employee’s salary income for that financial year and taxed at the applicable income tax slab rates.

Tax Deduction at Source (TDS): The employer deducts TDS on the full amount of leave encashment and includes it in the employee’s Form 16 under the “Salary” section.

No Exemptions: No exemptions are available for leave encashment received while still employed.

Example:
If an employee receives ₹1,00,000 as leave encashment during service, the entire amount is added to their gross salary and taxed accordingly.

2. Leave Encashment at Retirement, Resignation, or Termination

When leave encashment is received upon retirement, resignation, or termination, non-government employees are eligible for partial exemption under Section 10(10AA)(ii) of the Income Tax Act, 1961.

The exempt amount is calculated as the least of the following:

1. Actual Leave Encashment Received 

2. ₹25,00,000

3. 10 Months’ Average Salary: Based on the average salary (basic salary + dearness allowance, if applicable) of the last 10 months immediately preceding retirement/resignation.

4. Cash Equivalent of Unavailed Leave: The cash equivalent of earned leave calculated as follows: Earned Leave Days×Average Daily Salary (Earned leave is capped at 30 days per year of service).

3. Calculating Taxable Leave Encashment

Example:
An employee retires after 20 years of service with the following details:

• Earned leave balance: 240 days (30 days per year of service).
• Average monthly salary (basic + DA): ₹60,000.
• Leave encashment received: ₹5,00,000.

Step-by-Step Calculation:

1. Actual leave encashment received: ₹5,00,000.
2. ₹25,00,000 
3. 10 months’ average salary: ₹6,00,000 (₹60,000 × 10).
4. Cash equivalent of earned leave:
   • Earned leave: 240 days.
   • Daily salary: ₹60,000 ÷ 30 = ₹2,000.
   • Cash equivalent: 240 × ₹2,000 = ₹4,80,000.

The least of these amounts is ₹4,80,000, which is exempt from tax.
The taxable portion is:

Taxable Amount=Actual Encashment Received−Exempt Amount=₹5,00,000−₹4,80,000=₹20,000.

Documents Required for Claiming Leave Encashment Exemption

To claim leave encashment exemption under Section 10(10AA) of the Income Tax Act, the following documents are typically required:

• Leave Encashment Certificate: A document from the employer stating the total leave encashment amount paid, the calculation of earned leave, and the period of service.
• Form 16: This includes details of the leave encashment amount paid, TDS deducted, and other salary-related information.
• Salary Slips: Monthly or yearly salary slips to verify the basic salary and dearness allowance (if applicable) for calculating the exemption limit.
• Leave Balance Statement: A record from the employer showing the accumulated earned leave balance and its encashment.
• A self-prepared computation sheet showing the exemption calculation under Section 10(10AA).
• Proof of retirement or resignation from the organization for leave encashment received after cessation of employment.

Conclusion

Understanding leave encashment taxation is vital to managing your finances efficiently. While government employees enjoy complete tax exemption, non-government employees must carefully navigate exemption limits and rules. Always consult a CA to ensure compliance and optimize tax savings.

By staying informed and planning strategically, you can make the most of your leave encashment benefits while minimizing tax liabilities.

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FAQs

Q1: Can leave encashment be received in installments?
A1: Yes, some employers allow encashment in installments, but the tax treatment remains the same.

Q2: Is leave encashment exemption available under the new tax regime?
A2: Yes, leave encashment rules remain unchanged under the new tax regime and hence exemption is available.

Q3: Does leave encashment impact TDS deductions?
A3: Yes, employers deduct TDS based on the taxable portion of the leave encashment amount.

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