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Leave Encashment: Tax Exemption, Calculation & Examples

Leave encashment is a policy that allows employees to convert their unused or accumulated leave days into cash or a monetary benefit. It provides employees with compensation for the unused portion of their earned leave when they leave employment or as per the rules set by their organization. In this article, we will discuss the tax implications of leave encashment, the calculation methods, and provide examples to help you understand how it works.

What is Leave Encashment?

Leave encashment refers to the compensation or payment made in return for unused leaves. Employees can encash their accumulated leave at any moment during their employment, retirement, or as per the organization's policy. Some organizations allow employees to carry over their unused vacation time from one year to the next, while others reimburse employees for unused leaves in the next calendar year. When an employee leaves a job, the company pays for any unused paid leaves.

Types of Leaves

There are various types of leaves provided to employees, each with its own set of rules and regulations. Here are some of the common types of leaves:

  1. Casual Leave: This type of leave can be taken for a maximum of seven days and requires prior information to the employer. It may be considered for leave encashment if it is allowed to be carried forward as per the company's policy.
  2. Privilege Leave: Privilege leave is paid leave that can be availed by providing prior information to the employer. If not availed, employees can accumulate and encash them later, subject to the organization's regulations.
  3. Medical Leave: Medical leave can be availed by employees who are sick and unable to work. The number of medical leaves granted depends on the organization, and such leaves are paid. However, medical leave is not considered for leave encashment.
  4. Maternity Leave: Maternity leave is provided to pregnant female employees during their employment period. The leave is paid for a specified duration, but the extended leave period is unpaid. Maternity leave cannot be considered for leave encashment.
  5. Quarantine Leave: Quarantine leave can be availed if an employee or their family members are affected by an infectious disease. This leave cannot be considered for leave encashment.
  6. Sabbatical Leave: Sabbatical leave is granted to employees who want to pursue further studies or specialized training relevant to their working field. These leaves are paid for a specific period as decided by the organization and cannot be considered for leave encashment.
  7. Paternity Leave: Paternity leave is available for employees who become fathers, but only government employees may avail of this benefit. The leave can be granted before or after the birth of a child and cannot be considered for leave encashment.
  8. Holidays: Holiday leaves are paid leaves and include national holidays, festivals, and weekly offs. These leaves are considered for leave encashment.
  9. Half-pay Leave: Half-pay leave is available only to government employees, and they receive a half-day's salary during their leave period. Inclusion of these leaves during leave encashment depends on government regulations.

Providing these leaves has multiple benefits for employees and the organization. It allows employees to balance their work-life and provides them with the flexibility to handle emergencies, expand their knowledge, and spend quality time with their loved ones. For organizations, it improves employee morale and adds value to the business through skilled and knowledgeable employees.

The Process of Leave Encashment

The process of leave encashment varies for government and private sector employees. Here is an overview of how it works:

Leave Encashment During Employment

If an employee wants to encash their unused paid leave during their employment period, it is considered as income from salary and is taxable. However, employees can claim tax relief under Section 89 of the Income Tax Act. To claim tax relief for leave encashment, employees need to fill out Form 10E, which is available on the e-portal of the income tax department.

Leave Encashment After Retirement or Resignation

At the time of retirement or resignation, employees can avail of leave encashment through their accumulated paid leave. The tax implications and exemptions for leave encashment after retirement or resignation depend on the type of organization.

  • For employees of central or state government organizations, leave encashment is fully exempt from tax.
  • In the case of an employee's death before leave encashment, their legal heirs can receive the total amount without any income tax deductions.
  • Employees working in the private sector can receive paid leave encashment at the time of retirement or resignation. The maximum tax exemption amount was previously Rs 3,00,000, but it has been increased to INR 25,00,000 in the new finance budget for 2023. Any amount exceeding this value is taxable. The calculation of exempt leave encashment is as per Section 10(10AA) of the Income Tax Act.

If you are unsure about the tax implications of your leave encashment or facing difficulties in claiming the tax properly, it is recommended to seek professional advice. Tax experts can help you claim deductions, maximize your savings, and ensure a smooth filing.

Income Tax Exemption Under Section 10(10AA)

The taxability and exemption related to leave encashment can be understood as follows:

  • Any amount received as leave encashment during employment is fully taxable.
  • Any leave encashment amount received by an employee of the central or state government is fully exempt from tax.
  • For employees other than those mentioned above, the leave encashment amount is exempt up to a certain limit, which is the average salary of the last 10 months. This includes basic salary, dearness allowance, and commission received during that period.
  • It is important to note that the number of paid leaves considered for leave encashment calculation is a maximum of 30 days per year, as per the provision of the Income Tax Act.
  • Legal heirs of deceased employees can receive the leave encashment amount without any tax deductions.
  • In the case of resignation or termination, both government and non-government employees are required to pay tax on the amount received from paid leave encashment, as it is considered income from salary by the income tax department.

How is Leave Encashment Calculated?

Leave encashment received by government employees is tax-free. For private employees, leave encashment is calculated based on the following factors:

  • Actual amount received as leave encashment
  • The maximum amount stated by the government, which is currently INR 25,00,000
  • Last 10 months of basic salary and dearness allowance
  • Salary per day multiplied by unutilized leave (consider a maximum of 30 days leave per year) for every year of completed service

To illustrate the calculation, let's consider an example:

Mohan has retired from the organization after serving for 20 years. He was entitled to 32 days of paid leave in a year but only used 275 leaves, leaving him with 365 days of leave. His basic salary + D.A. at retirement was INR 30,000 per month. He received a leave encashment of INR 365,000 (365*1000).

The taxable leave encashment amount will be the actual amount received, which is INR 365,000. The exemption under section 10(10AA) will be the least of the following:

  • Average salary of the last 10 months: INR 300,000
  • 30 leaves per year allowed (3020-actual leave taken)1000: INR 600,000
  • Maximum allowed: INR 25,00,000

Therefore, the lower of all the values is exempt, which is INR 300,000. The taxable leave encashment amount will be INR 65,000 (365,000 - 300,000).

Leave Encashment and Tax Implications in a Nutshell

To summarize the tax implications of leave encashment:

  • If you encash your leave while still employed, the money is taxable without exception.
  • Government employees, whether federal or state, do not have to pay tax on leave encashment income when they retire.
  • Private sector employees who receive leave encashment after retirement or resignation are subject to 'Income from Salary' taxation, with some exemptions applying to the income. The remaining amount will be added to their normal income and taxed according to the income tax slabs after considering the exemption.
  • Section 10(10AA) of the Income Tax Act exempts private sector employees from paying taxes on their leave encashment income.
  • It is important to consult a tax professional if you have any doubts about the tax implications of your leave encashment or need assistance in claiming proper deductions and exemptions.

Frequently Asked Questions

Q: Can leave encashment be withheld? A: Leave encashment can be withheld if the employee faces a criminal case or any departmental proceedings at the time of retirement.

Q: Is leave encashment taxable on resignation? A: Leave encashment is taxable if it is received on resignation.

Q: What is leave encashment? A: Leave encashment refers to the conversion of unavailed leave into cash or a monetary benefit.

Q: What is the provision for leave encashment? A: The provision for leave encashment is that a maximum of INR 25,00,000 is exempt for non-government employees, while it is fully tax-free for government employees.

Q: How many leaves can be encashed? A: The number of leaves that can be encashed depends on the organization, but it is generally limited to a maximum of 30 days of earned leave per year.

Q: Can casual leave be encashed? A: Whether casual leave can be encashed depends on the policy of the company. If casual leave is paid on certain days, it can be encashed.

Q: Is leave encashment taxable for bank employees? A: Yes, leave encashment is taxable for bank employees, subject to certain conditions.

Q: Is leave encashment a perquisite? A: The amount received as leave encashment is considered a perquisite for the employee, and the tax implications depend on whether the leaves are encashed during employment or at the time of retirement.

Q: How does the gratuity benefit work for employees? A: Gratuity is a benefit given by the employer to employees. The recent amendment has increased the exemption limit for gratuity to INR 20,00,000 from the previous limit of INR 10,00,000.

In conclusion, leave encashment is a valuable benefit provided to employees, allowing them to convert their unused leave into cash. However, it is important to understand the tax implications and exemptions associated with leave encashment to ensure proper compliance with income tax regulations. By following the guidelines and seeking professional advice if needed, employees can maximize their savings and enjoy the benefits of leave encashment without any tax-related issues.

author

The Tax Heaven

Mr.Vishwas Agarwal✍📊, a seasoned Chartered Accountant 📈💼 and the co-founder & CEO of THE TAX HEAVEN, brings 10 years of expertise in financial management and taxation. Specializing in ITR filing 📑🗃, GST returns 📈💼, and income tax advisory. He offers astute financial guidance and compliance solutions to individuals and businesses alike. Their passion for simplifying complex financial concepts into actionable insights empowers readers with valuable knowledge for informed decision-making. Through insightful blog content, he aims to demystify financial complexities, offering practical advice and tips to navigate the intricate world of finance and taxation.

Frequently Asked Questions

Leave encashment refers to the process where an employee receives monetary compensation for the accumulated or unused leave days at the time of retirement, resignation, or as per company policy.

As per Section 10(10AA) of the Income Tax Act, leave encashment received by a government employee at the time of retirement or superannuation is fully exempt from tax. For non-government employees, exemption is available subject to certain limits and conditions.

The tax exemption on leave encashment is calculated based on the least of the following amounts: actual amount received, the amount specified by the government (currently ₹3 lakhs), or the amount calculated as per the formula [(last drawn salary / 10) x number of leave days encashed].

Sure. Suppose an employee's last drawn salary is ₹50,000 per month, and they encashed 100 days of leave. The tax exemption on leave encashment would be [(50,000 / 10) x 100], which equals ₹5,00,000. However, since the government limit is ₹3 lakhs, the exempted amount would be ₹3 lakhs.

Yes, leave encashment is taxable as per the Income Tax Act, unless specifically exempted under certain conditions.

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