Leave Encashment Taxability In India

During employment, you may receive periods of time off known as “leave.” Some employers offer paid leave, but you should be aware that there may be tax implications if you receive payment for unused leave days. This concept is known as “leave encashment taxability” and refers to whether you are required to pay taxes on those payments.

What Is Leave Encashment?

If you accumulate unused paid leave while working, it can remain with you until you retire or leave the company. When you leave, the company is required to compensate you for the leftover leave, which is called “leave encashment.” This payment may be subject to tax rules, determining whether you owe taxes on the compensation received for your unused leave days.

Leave Encashment Taxability in India

Payments for unused leave while employed are subject to taxation. However, when retiring (regardless of age or reason), leave encashment are tax-free. This is pursuant to Section 10(10AA) of the Income Tax Act. In conclusion, regular leave payouts are taxable, while leave encashment at retirement are exempt. Here is the breakdown of leave encashment taxability as per the Income tax Act, 1961.

Nature of Leave Encashment	Leave encashment received by	Taxability
Leave Encashment received during the terms of employment	Government or Non-Government employees	It is fully taxable (relief can be taken u/s 89)
Leave Encashment received at the time of retiring / leaving job	Government employees	It is fully exempt u/s 10(10AA)[i]
Leave Encashment received at the time of retiring / leaving job	Non-government employees	It is partly exempt and partly taxable. The exemption is calculated on the basis of Section 10(10AA)(ii).
Leave Encashment received after death of employee	Legal heir of a deceased employee	Leave encashment received by the Legal heir of a deceased employee is fully exempt in the hands of the legal heirs.

However it is not a must for employees to use all their entitled leave each year. In fact, many employers offer the choice to carry forward any unused paid leave to the following period.

Leave Encashment Taxability On Retirement

The Income Tax Act, 1961 gives a complete exemption for leave encashment received upon retirement for government employees.

However, leave encashment is exempt from tax for non-government employees (including those working for local authorities or statutory corporations) u/s 10(10AA). This exemption is the lower of the following:

Cash equivalent of unutilized leave, based on a maximum of 30 days leave for each year of actual service.
10 times the average monthly salary.
An amount specified by the government, currently set at Rs. 300,000.
The actual leave encashment received upon the retirement.

Leave Encashment Exemption u/s 10(10AA)(ii)

Under Section 10(10AA)(ii), the specified exemptions for leave encashment are determined by the least of the following:

The government notified amount, currently at Rs. 2500,000.
The actual leave encashment amount received
The average salary over the last 10 months, which includes basic salary, dearness allowance, and turnover commission.
The salary per day multiplied by the unutilized leave (considering a maximum of 30 days per year) for each completed year of service)

Here, Salary means Basic salary + Dearness Allowance + Turnover Commission.

For example

Mr. A, a non-government employee is retiring after 10 years:

Leave Encashment Received: Rs. 200,000 (for 200 unused days at Rs. 1,000 per day)
Exempt Amount: Rs. 200,000

Now, let’s get the taxable amount which must be the least of the following:

Government notified amount: Rs. 25,00,000
Actual Leave Encashment: Rs. 2,00,000
Average Salary for 10 Months: Rs. 3,00,000 (Rs. 30,000 * 10 months)
1,000 * (30 days * 10 completed years – 200 days utilized): Rs. 1,00,000

So, Taxable Leave Encashment (Income from Salary): Rs. 1,00,000

Recent High Court Judgment On Leave Encashment Taxability of Bank Employees

In a recent court case, a former employee of State Bank of India argued that the tax law on leave encashment (Section 10(10AA)) is unfair to employees who work for private companies compared to those working for the government.

The employee claimed that after working for 36 years, he received leave encashment with taxes deducted, while government employees in the same situation do not have to pay taxes on this payment due to Section 10(10AA). The employee argued that this difference in treatment violates the Constitution’s principle of equality before the law.

However, the High Court ruled that the differentiation between private and government employees in this case is a reasonable distinction based on the different nature of their employment. This decision aligns with previous judgments by the Apex Court, establishing that such a distinction is justified.

Conclusion

It is important to know about leave encashment taxability, particularly when considering retirement benefits. The taxable portion depends on factors such as the government’s set limit, the actual amount received when cashing out leave, and one’s average salary. While leave encashment can be a great perk, it is essential to understand the tax implications to make sound financial plans.