Labour Laws in India mandates for paid leave every year to employees. Employees who can not utilise the paid leave, Employers allow employee to carry forward unutilised paid leaves to further years and to encash at the time of retirement or resignation etc.

The encashment of such unutilised paid leave are known as Leave Encashment.

Taxability of Leave Encashment

The Leave Encashment received is taxable Income under the head of Salary as per Income Tax Act, 1961 subject to certain exemptions discussed below :-

1. Leave Encashment received during the Service Period :- Leave encashment received during the service period is Taxable income under the head salary (irrespective of Government employee or not). Thought relief under section 89 can be claimed (Circular :  431 [F.  No. 174/43/82-IT (A-II)], dated 12-9-1985)

2. Leave Encashment Received at the time of Retirement or resignation :-

3. By Central or State Govt. Employees – Fully Exempt U/s 10 (10AA) (i)

4. By Legal heirs of deceased employee – Fully Exempt (F.35/1/65-IT(B), dated 5-11-1965)

  • By Non Govt. Employees – Exempt as per Limits 10(10AA)(ii) Rest amount is taxable.

Technical Analysis of Section 10(10AA)(ii)

Extracts of Section 10 (10AA)(ii) from Income Tax Act,1961 are –

any payment of the nature referred to in sub-clause (i) received by an employee, other than an employee of the Central Government or a State Government, in respect of so much of the period of earned leave at his credit at the time of his retirement whether on superannuation or otherwise as does not exceed ten months, calculated on the basis of the average salary drawn by the employee during the period of ten months immediately preceding his retirement whether on superannuation or otherwise, subject to such limit as the Central Government may, by notification in the Official Gazette, specify in this behalf having regard to the limit applicable in this behalf to the employees of that Government :

Provided that where any such payments are received by an employee from more than one employer in the same previous year, the aggregate amount exempt from income-tax under this sub-clause shall not exceed the limit so specified :

Provided further that where any such payment or payments was or were received in any one or more earlier previous years also and the whole or any part of the amount of such payment or payments was or were not included in the total income of the assessee of such previous year or years, the amount exempt from income-tax under this sub-clause shall not exceed the limit so specified, as reduced by the amount or, as the case may be, the aggregate amount not included in the total income of any such previous year or years.

Explanation.—For the purposes of sub-clause (ii),—

the entitlement to earned leave of an employee shall not exceed thirty days for every year of actual service rendered by him as an employee of the employer from whose service he has retired

Analysis

Clause (ii) clearly says this section is applicable to Employees other than employees of central and state government. This is to be noted that PSU and Nationalised Bank employees are considered as Non Govt. Employees and covered under this clause only. (Kamal Kumar Kalia & Ors Vs Union of India & Ors. (Delhi High Court). Further the Limits can be read as follows for exemption under this clause, rest amount will be taxable under the head Salary.

1. Actual Leave Encashment Received. (obviously the exempt amount can not exceed the amount received for leave encashment.

2. Maximum 10 month Salary (Salary will be average of last 10 month salary drawn immediately preceding retirement or resignation)

3. Maximum Limit as notified having regard to the limit applicable in this behalf to the employees of that Government.

4. The amount of unutilised Leave considering maximum 30 days leave per year for every completed year of service.

Note :-  Salary = Basic + Dearness Allowance + Commission based on fixed percentage of turnover.

Let us analysis the point iii) as mentioned above.

The clause ii) to Section 10(10AA) directs central government to prescribe the maximum amount of exemption applicable to Non Govt. Employees. Further such specified limit should be prescribed having regard to the limit applicable to the employees of central government. So there has been two sentence which should be read as that first central government will prescribe the limit and second such limit should be as per limit as of employee of that government.

The government was not intended to discriminate between the non government employee and government employees with respect to availing the exemption under section 10(10AA) and hence provided the language so.

Now in this behalf following notifications has been issued:-

Notification S.O.1015(F) dated 08.06.1988

Notification 10043/F. No. 200/106/95-ITA-I dated 26.03.1996

Notification 10749/F.No.200/23/98-ITA-1 dated 27.11.1998

Notification 123/2002/F. No. 200/23/98-ITA-I dated 31.05.2002

The latest notification issued in this behalf was dated 31.05.2002 applicable for employees retired from 01.04.1998, now after passing almost 24 years from 01.04.1998, no notification has been issued. Multiple Pay commissions have come into the force and payout to employees in these years has been increased but the limit being static. It was the duty of Central Government to notify the limit time to time as mandated by Law.

The other part of Point iii) says that limit should be such having regard to the limit applicable to the employees of central government, the reason behind writing such a condition would have been (in the opinion of author) that employees belonging to private sector organisation/companies should not get the exemption more than the limit as of Government Employee. Further if government had exempted all amount received as leave encashment in case of Non govt. Employees (as done in clause i for govt. Employees ) there is chance of misappropriating the section and allocating more amount for leave encashment for tax benefit. Now for the purpose of putting Salary capping (maximum limit), govt. has given condition of maximum amount to be specified through notification. Also through explanation to clause ii, government has put capping on maximum number of days for paid leave in year for the purpose of calculation of exemption under this clause, so that no one can misutilise the exemption.

Now it is clear that intention for putting the condition of limit to be specified through notification is to putting cap on wrong utilisation of section and not giving more exemption to non government employees as compared to central government employees.  As per note sheet issued for the purpose of determining limit of Rs 3,00,000/- it is clearly written that government has taken Rs 30,000/- per month keeping in view the maximum basic pay admissible at that time. Such amount was multiplied by 10 as per note sheet and limit of Rs 3,00,000 was withdrawn at that time. Now the maximum basic pay  of central government employee (as of now of Cabinet Secretary) is approx. 2.5 lac per month. And on this basis this limit should be 25 lac or more.

Now it was the duty of central government to specify the limit of exemption by working out on the basis of condition provided in law itself. Government has failed to specify the same, and non government employees are paying taxes more than what they should do. Now in absence of notification claiming exemption more that Rs 3,00,000 may attract litigation but non claiming will result in more tax or less refund. This fact also admitted in case of Kamal Kumar Kalia & Ors Vs Union of India & Ors. (Delhi High Court) and court has admitted that limit should be enhanced.

Author Bio

Qualification: CA in Practice
Company: RUPENDRA SHARMA & ASSOCIATES
Location: JAIPUR, Rajasthan, India
Member Since: 26 Mar 2021 | Total Posts: 1

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7 Comments

  1. CA Rupendra Sharma ji, It’s mean that AO may restrict the exemption to Rs 300000/- where PSU Retirees claim full exemption and to get relief Assessee need to move for appeal.

    Further, AO may also initiate penalty for under reporting of Income.

    Please share your view for share your contact number for discussion. My whatsapp No 9868230576

    1. CA Rupendra Kumar Sharma says:

      Dear Sir, Happy Holi !
      Sir AO will certainty restrict as he is officer of govt and in my opinion he will do what is on record, and not on the basis of what should be on record. So he will restrict exemption to 300000, but if the assessee feels that exemption should be more than 300000 and ready for litigation then should go for claiming more exemption.
      But for penalty proceeding assessee is having some ground for claiming the exemption beyond rs 300000 so in my opinion penalty will not be imposed.

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