Here is all about Leave Encashment and its Tax Implications:
Mr. Anurag Basu has been working with a private company for 25 years and will be retiring in March 2017. He has some leaves under his credit and would like to encash those leaves at the time of retirement. He also wanted to know about the actual amount he will receive as leave encashment and the tax implication on the amount received.
A lot of us will have similar queries on leave encashment and its tax implications. In this article, I will give you a brief introduction on leave encashment, various events under which you can encash your leaves and the tax implication on leave encashment for the Government and Non-Government employees.
What is Leave Encashment?
During your service tenure, you are allowed to avail many leaves such as earned/privilege leave, medical/sick leave, casual leave, special casual leave, compensatory leave, etc. Among them, there are leaves which you can carry forward to the succeeding year such as earned leave and some of them cannot be carried forward like casual leave, compensatory leave.
All the above leaves are covered based on their applicability to establishments, under the Factories Act, 1948 and the Shops & the Establishments Act, 1961 and are calculated from the first day of January to the last day of December for a calendar year.
If the employee does not avail the earned leaves during the specified period allowed to him/her, such leaves may get lapsed, or they may be accumulated or encashed in the subsequent period based on the service rules in force. Encashment of leaves against the leaves not availed by the employee is known as Leave Salary. The number of leaves allowed to be taken and the leave encashment varies from employer to employer based on their leave policy.
Leave Encashment Schedule
An employee can avail for leave encashment under the influence of any of the event mentioned below:
• During the continuation of service
• At the time of Retirement/Resignation (other than the termination)
• Termination of the employee
Tax Implication on Leave Encashment
For the calculation of Tax liability under Section 10(10AA) of the Income Tax Act, 1961 on leave encashment, employees are categorised into two classes:
1. Government employees (State and Central Government employees)
2. Non-Government employees
1. Leave Encashment during the service tenure
Leave encashment during the service tenure is fully taxable in the hands of the Government as well as the Non-Government employees in the year of encashment. However, relief under Section 89 if applicable can be availed by the employee.
2. Leave Encashment on Retirement/Resignation
This is further based on the above classification of employees:
• Leave encashed by the Government employee at the time of Retirement/Resignation:
Any amount received by a State or a Central Government employee in the form of leave salary against the leaves accumulated on retirement/resignation is fully exempt from tax under Section 10(10AA)(i).
For example, Mr. Ajay Ratra is a Government employee and he is entitled to 28 days of leave per year. He has a credit of 400 days of leave in his account. He retired in the year 2015-16 and received Rs. 4,00,000 at the time of retirement on leave encashment. In this scenario, the entire amount received by Mr. Ajay Ratra i.e. Rs. 4,00,000 is fully exempt from tax.
• Leave encashed by the Non-Government employee at the time of Retirement/Resignation:
In case of a Non-Government employee, any amount received against the leaves accumulated on retirement/resignation is exempt from tax to a specified limit under Section 10(10AA)(ii) and will be the least of the following:
• Cash equivalent to earned leaves (Period of earned leaves in months * Average monthly salary)
• 10 month’s average salary
• Leave encashment actually received at the time of retirement
• Maximum amount as specified by the government i.e. Rs. 3,00,000 for the employees retiring after April 01, 1998
Computation of cash equivalent to earned leaves:
It involves the below steps:
Step I: Identification of the number of completed years of service (excluding part/fraction of the year)
Step II: Identification of the number of days of leave entitled for each service year as per the service rules (leave entitlement should not exceed a maximum of 30 days in a service year)
For instance, if leaves are credited at the rate of 40 days in a service year, then for the computation purpose in Step II, it should be restricted to 30 days per year. On the other hand, if the leaves are credited at the rate of 25 days in a service year, then the computation should be done taking into account; 25 days.
Step III: Computation of the Gross total leaves (In Days) (Step I * Step II)
Step IV: Identification of the leaves availed or encashed during the period of service (In Days)
Step V: Computation of the period of earned leaves (In Days) (Step III – Step IV)
Step VI: Computation of the period of earned leaves by dividing the number of days arrived in Step V by 30 (In Months)
Computation of Average monthly salary:
Average monthly salary is computed from the monthly salary drawn by the employee in the past 10 months immediately preceding the retirement i.e. the day of the retirement. Salary includes the below components:
• Dearness Allowance (if any)
• Commission based on the fixed percentage of the turnover achieved by the employee
Note: Apart from the above elements, no other allowances or perquisites are taken into consideration.
Let me take you through an illustration to understand the above calculation:
Mr. Rakesh Malya is a Non-government employee and has retired on June 30, 2016. His total service tenure is 30 years and 8 months. In agreement with his service rules, he is entitled to leave of 40 days per year for completed year of service. Below table represents some other details on leaves and salary: (Assuming that his salary has not changed in the past 1 year)
1. Computation of cash equivalent to earned leaves
2. Computation of 10 month’s average monthly
3. Computation of Leave salary exempt under Section 10(10AA)(ii)
4. Computation of total taxable Leave salary
Let me take you through each of the computations in detail:
1. Computation of cash equivalent to earned leaves:
There are 3 steps involved in the computation of the cash equivalent to earned leaves:
Step I: Compute the period of earned leaves in months:
In the above example, Mr. Rakesh Malya is entitled to avail 40 days leave per year for completed year of service. However, as per the rule if the leave encashment exceeds 30 days in a year, then it should be restricted to 30 days for the computation purpose. Below table illustrates the computation:
Step II: Compute Average monthly salary:
It is computed as below:
Basic salary per month in the past 10 months preceding the retirement + Dearness allowance per month in the past 10 months preceding the retirement
= Rs. 50,000 + Rs. 20,000 = Rs. 70,000
Step III: Compute cash equivalent to earned leaves:
It is computed using the formula mentioned below:
Leave available at the time of retirement (In months) * Average monthly salary
= 8 months * Rs. 70,000 = Rs. 5,60,000
2. Computation of 10 month’s average monthly:
It is computed by multiplying the average monthly salary to 10 months i.e.
= Rs. 70,000 * 10 months = Rs. 7,00,000
3. Computation of Leave salary exempt under Section 10(10AA)(ii):
It is the least of the values in the table below:
From the above table, the amount of leave salary exempted under Section 10(10AA)(ii) is Rs. 3,00,000 being least among all.
4. Computation of total taxable leave salary:
3. Leave Encashment on the termination of the employee
The amount received on leave encashment is fully taxable in the hands of both the Government as well as the Non-government employees.
Tax Implication on Leave Encashment
Below table illustrates the tax implication on leave encashment/leave salary amount entitled to the Government and the Non-Government employees under various circumstances:
Important points to remember
• In case of an employee receiving leave salary from multiple employers in the same year, the maximum exemption allowed under Section 10(10AA)(ii) cannot exceed the amount specified by the government i.e. Rs. 3,00,000.
• In case of an employee claiming exemption of leave salary under Section 10(10AA)(ii) in the earlier years, the maximum amount of Rs. 3,00,000 has to be adjusted by the amount of exemption earlier claimed.
For instance, Mr. Atul Sahani retired from the company ABC Ltd. in Oct 2010 and received a leave encashment of Rs. 80,000 (entire amount being qualified for exemption). Post his retirement from ABC Ltd; he joined another company XYZ Ltd. He retired from XYZ Ltd. in June 2016 and received a leave salary of Rs. 1,00,000. In such a scenario, the maximum amount available for exemption from XYZ Ltd. will be restricted to Rs. 2,20,000 (Rs. 3,00,000 – Rs. 80,000).
• Any leave encashment/ leave salary amount received by the nominee/legal heir in case of the death of the employee is fully exempt from tax.