Leave encashment and its taxability

As per Revenue Secretary, Ministry of Finance, post-budget interactions that proposed a higher tax relief of Rs 22 lakh at 30% plus works out to almost Rs 7 lakh

As per Indian labour laws, salaried employees are entitled to various types of leaves while they are in service. These leaves may be availed or one could encash the unutilised paid leaves every year or as accumulated over a period of time, to say, in a single go after resignation or retirement or death by his/her legal heir, as the case may be. For instance, an employee is entitled to 50 days of paid leaves in a year but avails only 20 of them during the year. Depending on the employer’s rules, an employee will be allowed to encash the said balance of 30 days of unutilised paid leaves. In most cases, an employee is allowed to encash it only at the time of resignation, retirement or death.

Leave encashment and its taxability: Like all other incomes, leave encashment is also taxable in the hands of an employee. The tax treatment can be summed up as:

a) Encashment during the tenure of service - fully taxable but allowed to claim tax relief under Section 89 subject to certain conditions and the employer is also under an obligation to deduct the applicable taxes at the source, and

b) Encashment of accumulated leave at the time of retirement – depending on the employment status, i.e. government or non-government, it will be fully exempted and partially exempted respectively.

In other words, in the case of a government employee, his encashment of accumulated leaves is fully exempt from tax, whereas, in the case of a non-government employee, it is exempted under Section 10(10AA)(ii) to the extent of the least amount of the following four:

i) Period of earned leave (in terms of month at the time of retirement/resignation X average monthly salary

ii) 10 X average monthly salary

iii) Leave encashment actually received

iv) Lump-sum amount specified by the central government, i.e. Rs 3,00,000 till the financial year ending March 31, 2023 or assessment year up to 2023-24.

Salary and average salary for the purpose of leave encashment: For computation purposes, salary includes dearness allowance, a fixed percentage of commission on turnover achieved by an employee, if any, but excludes all other allowances/perquisites. Average salary is the average of salary drawn by the employee in the 10 months immediately preceding his/her retirement.

Leave salary in the case of death: Leave salary received by the legal heirs of an employee is an ex-gratia payment and not in the nature of salary, hence, it will be fully exempted in the hands of the recipient.

Retirement for the purpose of leave encashment: Retirement includes superannuation or voluntary, such as resignation and previously mentioned rules apply equally as Madras High Court held in CIT v RJ Shahney (1986) 159 ITR 160 (Mad).

Supreme Court & Recent landmark verdict: The Supreme Court recently in ‘Jagdish Prasad Saini & Ors v State of Rajasthan & Ors (SLP (Civil) No 16813/2019)’ held that leave encashment is part of the salary and the State cannot shrug off its responsibility to shoulder its part of the responsibility to pay its share in leave encashment benefits.

Union Budget 2023: On February 1, 2023, Finance Minister Nirmala Sitharaman proposed a number of tax reliefs. One of them was a ‘hike in leave encashment exemption limit’ for non-government employees - it was proposed to raise tax exemption to Rs 25 lakh from the current Rs 3 lakh, which was last fixed in 2002. The Lok Sabha, with the said proposals, is likely to pass the Finance Bill, 2023, during the third/fourth week of March followed by the Rajya Sabha’s returning of it. With the Presidential assent, the new proposals will come into force from April 1, 2023 i.e. financial year 2023-24 or assessment year 2024-25 onwards.

As per Sanjay Malhotra, Revenue Secretary, Ministry of Finance, post-budget interactions that proposed a higher tax relief of Rs 22 lakh at 30 per cent plus works out to almost Rs 7 lakh. If one spreads the exemptions for over 30-35 years, it works out to more than Rs 20,000 gains a year. The central government is shortly going to notify the Finance Bill, 2023, that will ensure a big relief to non-government employees in the days to come.

(The writer is the founder and chief executive of Shree Tax Chambers)