Tax on Leave Encashment: Calculation, Exemption [AY 2021-22]

Employees are allowed to take leave for a fixed number of days throughout a year.

These leaves are paid i.e an employee’s salary will not be deducted if he takes leave within the employer’s policy.

Depending on the employer’s policy towards leave, in case of not using of the fixed leave, an employee can either carry forward the un-availed leave of a year to another year or sell that un-availed leave to the Employer [Also known as Leave Encashment]

In this article, we will cover the taxation of leave encashment.

Meaning of Leave Encashment 

Leave encashment means selling of un-availed leaves by an employee to his employer for an extra salary amount.

This encashment of un-availed leave can be either be at the time of retirement or during employment.

Income tax rule on leave encashment depends on the timing of encashment.

Income Tax Rule on Leave Encashment during the Employment period 

Leave encashment received during the employment by an employee is taxable in the year of such encashment.

As the received salary amount relates to one or more previous years, a taxpayer can claim tax relief of excess of current year’s tax rate over the tax rates prevailing in previous years to which such salary relates. [Under section 89]

Example:

Mr Nikunj, a government employee is entitled to 20 days of leave per year. He has a credit of 227 days left in his account. During the financial year 2019-20, he encashed leave of 46 days and received Rs. 92,000 on account of leave encashment.

In this case, Rs. 92,000 will be added to his salary income for the financial year 2019-20 [AY 2020-21] and will be fully taxed.

Income Tax Rule on Leave Encashment on Retirement or Resignation  

For this, the income tax rule is different for government employees and non-government employees.

For Government Employees 

Central Government and State Government employees are exempted from tax on leave encashment received at the time of retirement or resignation. [Under section 10(10AA)(i)]

For Non-Government Employees

Calculation of Exemption for Non-Government Employees [u/s 10(10AA)(ii)]

Leave encashed on retirement or resignation by a non-govt employee is not fully exempted.

The exemption is limited to the lowest of the following:

1. Actual money received
2. 3,00,000/-
3. Average Monthly Salary * Leaves in months

Leaves will be restricted to 30 days for each year of service and it should be less than 10 months.

Note:

1. Average Monthly Salary = Basic + Dearness Allowance (DA) forming part of retirement benefit + Fixed % of commission on turnover
2. Leaves in months = {Year of service x Entitled leave days in a year [up to 30 days] – Leave encashed during the employment in days} / 30
3. 3,00,000/- will be reduced by the amount of deduction claimed in earlier previous years. [see the example below]

Example:

In June 2019, Mr Nilesh retired from X Ltd. and received leave encashment of Rs. 93,000. Suppose the entire amount qualified for exemption u/s 10(10AA)(ii) in AY 2020-21.

After his retirement from X Ltd., he joined Y Ltd. In March 2021, he retired from Y Ltd. and received leave encashment of Rs. 2,20,000.

In this case, the maximum amount of exemption in respect of leave encashment received from Y Ltd. will be limited to Rs. 2,07,000/- (Rs. 3,00,000 – 93,000)

The remaining of leave encashment i.e Rs.13,000/- (2.2 lakh – 2.07 lakh) will be taxable as salary Income for the AY 2021-22. [Relief of 89 is available]

Leave Encashment Received by Legal Heir on Death of Employee 

Money received by legal heirs on the death of an employee is considered as a capital receipt in the hands of the heir and is therefore exempted from the income tax.

However, the legal heir is required to file a tax return in the name of the deceased employee and pay the appropriate tax on that leave encashment as salary income if-

1. The Employee dies after his retirement or resignation or termination, or
2. The Employee had withdrawn leave salary during the service of his employment and died after that.

Conclusion

Leave salary is taxable if withdrawn during the employment.

However, it will be fully exempted if withdrawn on –

1. Retirement or resignation by a Central or State Govt. Employee, or
2. The death of a retired employee and money received by his legal heir

Leave encashment received by a non-govt employee on retirement is partially exempted under section 10(10AA)(ii).