What is Leave Encashment? – Tax Exemption, Calculation & Examples

Salaried employees enjoy various types of paid leaves, including sick leave, casual leave, annual leave, and earned leave. The flexibility of carrying over these leaves to the next year depends on the employer’s established rules, with some organizations permitting indefinite carryovers. Leave encashment is a beneficial policy that allows employees to convert their unused or accumulated leave days into a monetary benefit, receiving compensation for the untaken portion of earned leave upon leaving employment or following organizational regulations.

In this comprehensive guide, we will explore the tax implications associated with receiving monetary compensation in lieu of accrued leaves.

What is Leave Encashment?

According to labour laws, every salaried individual is entitled to a minimum number of paid leave each year. However, it is not mandatory for an employee to utilize their entire allotted leave within a given year. Many employers provide the flexibility for employees to carry forward unused paid leave to subsequent periods.

As a result, employees often find themselves with an accumulated balance of unutilized leave at the time of retirement or resignation. In such cases, employers are obligated to compensate employees for the value of their accrued but unused leave. This practice is commonly referred to as leave encashment, wherein employees receive monetary compensation for the accumulated and untaken leave balance upon their departure from the company.

Budget 2023 Update

Notably, the leave encashment tax exemption limit for non-government employees, which was Rs. 3 lakh since 2022, has seen a substantial increase to Rs. 25 lakh. This adjustment is reflective of the general rise in income from salary.

Process of Leave Encashment

Leave encashment is a process that allows salaried government and private sector employees to derive additional benefits from their accumulated, unused leaves. This practice ensures that employees are entitled to certain work benefits, including pay scale, tax deductions, and leaves, which are generally similar across both sectors.

In the context of income tax regulations, employees may be liable to pay income tax if their annual income exceeds the limit specified by the income tax department. Employers typically deduct a portion of the employee’s salary, depositing this amount into the provident fund (PF) account. Provident funds serve as a financial resource accessible to employees throughout their employment and after retirement.

Besides salary and PF contributions, employers often provide additional incentives and allowances such as travel, food, and accommodation during an employee’s tenure. The organization may also offer insurance policies to cover health emergencies, with the option for employees to utilize the matured amount after retirement.

One notable aspect of employee benefits is the ability to carry forward unused leaves from one year to the next. Should an employee choose not to utilize these accumulated leaves during a given year, they can later opt for leave encashment. In simple terms, leave encashment allows employees to receive monetary compensation for the untaken leaves. This process serves as an additional benefit for employees, providing financial flexibility and acknowledging the value of their accrued time off.

Taxation and Leave Encashment

Taxation of leave encashment is subject to specific regulations based on the timing of the encashment – whether it occurs during the employment period or after retirement or resignation.

• Leave Encashment During Employment: When an employee seeks leave encashment for unused paid leave during their employment, it is considered taxable income under the category of salary. However, relief can be claimed under Section 89 of the Income Tax Act. To avail tax relief, the employee must complete Form 10E, which is accessible on the income tax department’s e-portal and can be submitted online.
• Leave Encashment After Retirement or Resignation: The conditions for leave encashment post-retirement or resignation vary based on the type of organization.
• Government Employees: Central or state government employees can claim full exemption from tax on their paid leave encashment.
• Deceased Employee: In the unfortunate event of an employee’s death before leave encashment, their legal heirs can receive the total encashment amount without incurring income tax.
• Private Sector Employees: Private sector employees can receive paid leave encashment at the time of retirement or resignation. The maximum tax exemption amount was Rs 3,00,000; however, the New Finance Budget 2023 increased it to INR 25,00,000. Any amount exceeding this value is taxable. The calculation of exempt leave encashment follows the guidelines of Section 10(10AA).

Income Tax Exemption Under Section 10(10AA)

Income tax exemption under Section 10(10AA) pertains to the taxability and exemption associated with leave encashment. Here is a breakdown of the tax implications based on different scenarios:

• Leave Encashment During Employment: Any amount received as leave encashment during employment is fully taxable. However, under Section 89 of the Income Tax Act, employees can claim tax relief on their leave encashment amount.
• Leave Encashment at the Time of Retirement: For Central or State Government employees, the entire leave encashment amount is fully exempt from tax. For other employees, the exempted amount is limited to the average salary of the preceding 10 months, including basic salary, dearness allowances, and commissions. This calculation is based on the salary received during the 10 months leading up to retirement or resignation.

Notes

• The Income Tax Act stipulates that, for non-government employees, only a maximum of 30 days of leave per year will be considered for calculating the exempted amount during retirement or resignation. The total number of paid leaves will be aggregated for the calculation.
• Legal heirs of deceased employees are eligible to receive the leave encashment amount without any tax deduction.
• In cases of resignation or termination, both government and non-government employees are required to pay tax on the leave encashment amount. This is treated as income from salary, and the tax rate applied is the same as that for income tax on salary.

Leave Encashment Calculation

Note: Salary for this purpose includes basic salary, dearness allowance, and commission based on a fixed percentage of turnover secured by the employee.

Specified amount of Rs 25,00,000 is the aggregate amount allowed as an exemption irrespective of the frequency of leave encashment received by the employee by various employers. If an employee has utilized Rs 5,00,000 already at the time of the first resignation, he is only entitled to use the balance of Rs 20,00,000 for the exemption computation next time. Hence, the overall employee is allowed a total exemption of only Rs 25,00,000 to leave encashed from all employers.

Example of Leave Encashment

• Mr. A, retiring after 15 years of service, had 525 days of leave entitlement (35 days/year x 15 years).
• Utilized 200 days of leave, leaving 325 days unutilized.
• Drawing a basic salary + DA of Rs 33,000 per month at retirement.
• Received Rs 3,57,500 as leave encashment (325 days * Rs 1,100).
• Exemption calculated as the least of the specified amounts, resulting in Rs 2,75,000 being exempt.
• Taxable leave encashment amount is Rs 82,500.

Tax planning can be based on the employer’s leave encashment policy and individual income, considering factors like the cost of inflation. The choice between annual leave encashment or a lump sum at retirement/resignation should be made accordingly.

Types of Leaves

The leave policy of a company delineates various types of leaves accessible to employees, each governed by specific durations and conditions. While these policies exhibit variability across companies, a general overview of common leave categories provides insight into the diverse options available:

• Casual Leave spans a duration of 7 to 10 days and serves personal purposes, though the encashment policies associated with these leaves may differ between companies.
• Earned Leave, or Privilege Leave, permits employees to take time off with prior notice, and eligibility for encashment typically comes into effect after a specific tenure, the details of which vary across organizations.
• Medical Leaves are granted when employees are unable to fulfill their duties due to health conditions. The maximum limit for these leaves is contingent on the policies established by individual firms.
• Holiday Leaves are at the discretion of employees, with no salary deductions for these periods of absence. The maximum number of holiday leaves is subject to variation between companies.
• Maternity Leaves, exclusively available for female employees, typically range from 12 to 26 weeks during pregnancy. While extensions are possible without payment, encashment is generally not an option for these leaves.
• Sabbaticals offer employees an opportunity to take leaves for upskilling and knowledge expansion. Employers often reimburse leaves for enrolled courses, fostering continuous learning and professional development.

Employees must acquaint themselves with their company’s leave policy specifics to comprehend the unique conditions, encashment options, and nuances associated with each leave category.

FAQs About Leave Encashment