Tax Treatment of ‘Leave Encashment’

Leave salary means the salary for the period of leave not availed by the employee. The encashment of accumulated leave can be at the time of retirement or during the continuation of service. The provisions relating to taxation of leave salary are as follows:

 

(A) Encashment of leave during the continuation of service :

Leave encashment received during continuation of service by Government or non-Government employees is charged to tax in the year of such encashment. However, relief under section 89 is available.

 

Illustration (Government employee)

Mr. Rupesh is a Government employee. He is entitled to 25 days’ leave per year. He has credit of 252 days’ leave in his account. During the year 2012-13 he encashed leave of 52 days and received Rs. 52,000 on account of leave encashment. In this case, Rs. 52,000 will amount to encashment of leave during the continuation of service and will be fully taxed in his hands.

 

Illustration (Non-Government employee)

Mr. Rupesh is working in Essem Ltd. He is entitled to 28 days’ leave per year. He has credit of leave of 384 days in his account. During the year 2012-13 he encashed leave of 84 days and received Rs. 84,000 on account of leave encashment. In this case, Rs. 84,000 will amount to encashment of leave during the continuation of service and will be fully taxed in his hands.

 

(B) Encashment of leave at the time of retirement :

Encashment of leave at the time of retirement can further be classified as : (i) leave encashment at the time of retirement by Government employee, and (ii) leave encashment at the time of retirement by non-Government employee.

 

(i)        Tax treatment in the hands of Central Government or State Government employees:

In case of a Central Government or State Government employee, any amount received for encashment of accumulated leave at the time of retirement/superannuation is exempt from tax under section 10(10AA)(i).

 

Illustration (Government employee)

Mr. Rupesh is a Government employee. He is entitled to 28 days’ leave per year. He has credit of leave of 484 days in his account. He retired in the year 2012-13. He received Rs. 4,84,000 on account of leave encashment at the time of retirement. In this case, Rs. 4,84,000 will amount to encashment of leave at the time of retirement and will be fully exempt from tax.

 

(ii)       Tax treatment in the hands of other employees

In case of non-Government employees (i.e., other than the Central or the State Government employees), leave salary exempt from tax under section 10(10AA)(ii) will be least of the following:

 

1.         Period of earned leave in months (*) × Average monthly salary (**)

 

2.         Average monthly salary (**) × 10 (i.e., 10 months’ average salary)

 

3.         Maximum amount as specified by the Central Government i.e., Rs. 3,00,000

Different amounts (i.e., ceiling limits) are specified by the Government for different years.

 

However, for employees retiring after April 1, 1998 specified ceiling limit is Rs. 3,00,000.

 

4.         Leave encashment actually received at the time of retirement.

 

(*) Period of earned leave in months is to be computed as follows :

 

Sl. No.

Particulars

1.

Number of completed years of service (i.e., ignoring part of the year)

2.

No. of days of leave entitlement for each year of service as per service rules (if leave entitlement as per service rules exceeds 30 days per year of actual service, then it should be restricted to 30 days)

3.

Gross total leave (in days) (i.e., 1 × 2)

4.

Leave encashed or availed during the continuation of service (in days)

5.

Period of earned leave (in days) (i.e., 3 - 4)

6.

Period of leave in months (i.e., days derived at 5 above ÷ 30)

 

(**) Meaning of average monthly salary

 

Average monthly salary means average salary drawn in past ten months immediately preceding the retirement (i.e., the day of retirement). Salary for this purpose will include following only:

 

Ø Basic salary,

Ø Dearness allowance considered while computing retirement benefits (i.e. DA in terms),

Ø Commission based on fixed percentage of turnover achieved by the employee.

 

Apart from above items, salary for this purpose does not include any other allowance or perquisites.

 

Illustration (Non- Government employee)

Mr. Kumar is working in Essem Ltd. at a monthly basic salary of Rs. 84,000. Apart from basic salary he is receiving following :

 

        Dearness allowance (forming part of salary while computing retirement benefits) of Rs. 16,000 per month.

        Dearness allowance (not forming part of salary while computing retirement benefits) of Rs. 50,000 per month.

 

        Fixed monthly commission of Rs. 10,000.

        Commission based on fixed percentage of turnover achieved by him Rs. 10,000 (@ 2% of turnover of Rs. 5,00,000 for the month).

        Children’s education allowance Rs. 1,000 per month for his two children.

        Medical allowance of Rs. 2,000 per month.

        Value of perquisites provided by the employer during the month Rs. 8,400.

There is no change in the above pay structure throughout the year 2012-13. If he retires in the month of April 2013, what will be the amount of average monthly salary to be used while computing exemption in respect of leave encashment at the time of retirement?

 

**

 

While computing average monthly salary for the purpose of exemption in respect of leave encashment at the time of retirement, salary will include following items :

 

        Basic salary,

        Dearness allowance considered while computing retirement benefits (i.e., DA in terms),

        Commission based on fixed percentage of turnover achieved by the employee.

 

Apart from above items, salary will not include any other item. Based on above, salary for the purpose of computing exemption in respect of retirement benefits will be computed as follows :

 

Particulars

(Rs.)

Basic salary

84,000

Dearness allowance (forming part of salary while computing retirement benefits)

16,000

Commission based on fixed percentage of turnover achieved by the employee

10,000

Monthly salary

1,10,000

 

OTHER POINTS:

        If an employee receives leave salary from more than one employer in the same year, then the maximum amount of exemption under section 10(10AA)(ii) cannot exceed the amount specified by the Central Government (i.e., Rs. 3,00,000).

        Where any employee has claimed exemption of leave salary under this section in any earlier year(s), then in case of such employee, the ceiling limit (i.e., Rs. 3,00,000) shall be reduced by the amount of exemption earlier claimed.

        Relief under section 89 is available in respect of leave salary.

 

Illustration (Non- Government employee)

In April 2004, Mr. Kumar retired from Essem Ltd. and received leave encashment of Rs. 84,000. Entire amount qualified for exemption. After his retirement from Essem Ltd. He joined SM Ltd. In March 2013, he retired from SM Ltd. and received leave encashment of Rs. 2,00,000. In this case, the maximum amount of exemption in respect of leave encashment received from SM Ltd. will be limited to Rs. 2,16,000 (Rs. 3,00,000 less Rs. 84,000 claimed earlier).

 

Illustration (Non- Government employee)

Mr. Kumar retired from Essem Ltd. (a private sector company) on 1-1-2013, after serving for a period of 25 years and 9 months. As per service rules, he is entitled to leave of 35 days for each completed year of service. Following are the details:

 

Leave availed during service period

184 days

Leave encashed during earlier years

252 days

Leave encashed during the year 2012-13 (Rs. 88,000)

44 days

Basic salary per month during 10 months preceding retirement

Rs. 40,000

Dearness allowance (per month) during 10 months preceding retirement:

(a) Forming part of salary for computing retirement benefits

Rs. 20,000

(b) Not forming part of salary for computing retirement benefits

Rs. 10,000

Leave salary received at the time of retirement

Rs. 7,90,000

 

From the above information, ascertain the amount of taxable leave encashment.

**

The exemption in respect of leave encashment in case of a non-Government employee at the time of retirement will be lower of the following amounts :

 

        Period of earned leave standing to the credit in the employee’s account at the time of retirement × average monthly salary.

        Average monthly salary × 10 (i.e., 10 months’ average salary).

        Maximum amount as specified by the Central Government, i.e., Rs. 3,00,000.

        Leave encashment actually received at the time of retirement.

 

Computation in this regard is as follows :

 

Total leave salary taxable for the assessment year 2013-14 will be computed as follows:

 

Particulars

(Rs.)

Total leave salary received at the time of retirement

7,90,000

Less: Leave salary exempt under section 10(10AA)(ii) (Note 1)

3,00,000

Taxable leave salary

4,90,000

(+) Leave encashment of 44 days received during the year 2012-13

88,000

Total taxable leave salary

5,78,000

 

Note 1: As per section 10(10AA)(ii), exemption in respect of leave salary received by a non-Government employee is least of the following:

 

Particulars

(Rs.)

1. Cash equivalent to earned leave (Note 2)

5,40,000

2. 10 months’ average salary (Note 3)

6,00,000

3. Maximum amount specified by the Central Government

3,00,000

4. Actual amount received

7,90,000

 

Amount of exemption under section 10(10AA)(ii) will be Rs. 3,00,000, being least of above.

 

Note 2: Computation of cash equivalent to earned leave:

 

Step 1: Computation of earned leave standing to credit at the time of retirement:

In this case, Mr. Kumar is entitled to 35 days’ leave for each completed year of service. If leave entitlement as per service rules exceeds 30 days per year, then it should be restricted to 30 days. Hence. while computing leave standing to credit, we will consider 30 days per year. Detailed computation will be as follows:

 

Particulars

Days

Total leave available during the tenure of service (30 days × 25 years)

[period of 9 months (i.e., fraction of year) is to be ignored]

750 days

Less: (a) Leave availed during service period

184 days

(b) Leave encashed during earlier years

252 days

(c) Leave encashed in previous year 2012-13

44 days

Leave standing to credit at the time of retirement

270 days

(÷) Days in month

30 days

Leave credit at the time of retirement

9 months

 

Step 2: Computation of average monthly salary:

 

As per section 10(10AA)(ii), salary for the purpose of computation of exemption is:

 

        10 months’ average salary immediately preceding the retirement (i.e., day of retirement and not the month of retirement).

        Salary will include basic salary, dearness allowance forming part of salary while computing retirement benefits and commission based on fixed percentage of turnover achieved by the employee.

 

Based on above, salary will be computed as follows:

 

Particulars

(Rs.)

Basic salary per month, for 10 months immediately preceding the retirement

40,000

Dearness allowance per month (forming part of salary while computing retirement benefits), for 10 months immediately preceding the retirement

20,000

Total monthly salary for the purpose of computing exemption

60,000

 

There is no need to convert aforesaid monthly salary of Rs. 60,000 into average monthly salary, since there is no change in salary during past 10 months.

 

Step 3: Computation of cash equivalent to earned leave:

 

= Leave standing to credit at the time of retirement × Average monthly salary

= 9 months × Rs. 60,000

= Rs. 5,40,000

 

Note 3: Computation of 10 months’ average salary:

 

10 months’ average salary will be computed as follows:

 

= Average monthly salary × 10 months

= Rs. 60,000 × 10 months = Rs. 6,00,000

 

Illustration (Non- Government employee)

Mr. Kumar retired from Essem Ltd. (a private sector company) on 1-1-2013, after serving for a period of 23 years and 7 months. As per service rules, he is entitled to leave of 33 days for each completed year of service. Following are other details:

 

Leave availed during service period

484 days

Leave encashed during earlier years

252 days

Basic salary per month during 10 months preceding retirement

Rs. 40,000

Dearness allowance (per month) during 10 months preceding retirement:

(a) Forming part of salary for computing retirement benefits

Rs. 20,000

(b) Not forming part of salary for computing retirement benefits

Rs. 10,000

Leave salary received at the time of retirement

Rs. 46,000

 

From the above information, ascertain the amount of taxable leave encashment.

**

The exemption in respect of leave encashment in case of a non-Government employee at the time of retirement will be lower of the following amounts :

 

        Period of earned leave standing to the credit in the employee’s account at the time of retirement × Average monthly salary.

        Average monthly salary × 10 (i.e., 10 months’ average salary).

        Maximum amount as specified by the Central Government, i.e., Rs. 3,00,000.

        Leave encashment actually received at the time of retirement.

 

Computation in this regard is as follows :

 

Total leave salary taxable for the assessment year 2013-14 will be computed as follows:

 

Particulars

(Rs.)

Total leave salary received at the time of retirement

46,000

Less: Leave salary exempt under section 10(10AA)(ii) (Note 1)

Nil

Taxable leave salary

46,000

 

Note 1: As per section 10(10AA)(ii), exemption in respect of leave salary received by a non-Government employee is least of the following:

 

Particulars

(Rs.)

1. Cash equivalent to earned leave (Note 2)

Nil

2. 10 months’ average salary (Note 3)

6,00,000

3. Maximum amount specified by the Central Government

3,00,000

4. Actual amount received

46,000

 

Amount of exemption under section 10(10AA)(ii) will be Nil.

 

Note 2: Computation of cash equivalent to earned leave:

 

Step 1: Computation of earned leave standing to credit at the time of retirement:

 

In this example, Mr. Kumar is entitled to 33 days’ leave for each completed year of service. If leave entitlement as per service rules exceeds 30 days per year, then it should be restricted to 30 days. Hence, while computing leave standing to credit, we will consider 30 days per year. Detailed computation will be as follows:

 

Particulars

Days

Total leave available during the tenure of service (30 days × 23 years)

[period of 7 months (i.e., fraction of year) is to be ignored]

690 days

Less: (a) Leave availed during service period

484 days

(b) Leave encashed during earlier years

252 days

Leave standing to credit at the time of retirement as per income-tax law

Nil

 

In this case, as per the computation prescribed under income-tax law, the employee is not having any credit of leave.

 

Note 3: Computation of 10 months’ average salary:

 

10 months’ average salary will be computed as follows:

 

= Average monthly salary (*) × 10 months

= Rs. 60,000 × 10 months = Rs. 6,00,000

 

(*) Computation of average monthly salary:

 

As per section 10(10AA)(ii), salary for the purpose of computation of exemption is:

 

        10 months’ average salary immediately preceding the retirement (i.e., day of retirement and not the month of retirement).

        Salary will include basic salary, dearness allowance forming part of salary while computing retirement benefits and commission based on fixed percentage of turnover achieved by the employee.

 

Based on above, salary will be computed as follows:

 

Particulars

(Rs.)

Basic salary per month, for 10 months immediately preceding the retirement

40,000

Dearness allowance per month (forming part of salary while computing retirement benefits), for 10 months immediately preceding the retirement

20,000

Total monthly salary for the purpose of computing exemption

60,000

 

There is no need to convert aforesaid monthly salary of Rs. 60,000 into average monthly salary, since there is no change in salary during past 10 months.

 
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