Of leave, encashment and taxes

Rules for accumulation, utilisation and encashment of leave vary with the employer

Salaried folk often get different kinds of leave such as casual leave, sick leave and privilege leave. The rules for accumulation, utilisation and encashment (conversion into money) of such leave could differ, depending on the employer. For instance, casual leave that accumulates in a year but not utilised within the year usually lapses without carry-forward or encashment; in such cases, it’s a good idea to use your casual leave during the year. Also, most employers do not allow encashment of unutilised sick leave; they may be allowed for carry-forward but with a cap on the days you can accumulate over the years, say, 45 or 60 days or more.

Then, there is privilege leave also known as earned leave. Here, employers usually allow carry forward of unutilised leave, though there could be a cap on overall accumulation over the years, say, 90 days or 180 days or more. Also, a portion, say, 15 days, of the unutilised privilege leave is often allowed to be encashed every year. And if you have unutilised privilege leave when you retire or resign, these could also be encashed.

The encashment amount is usually calculated on the basis of your latest monthly Basic Salary and Dearness Allowance amounts. Some employers project such entitlement of annual leave encashment as part of the cost-to-company of employees. Also, the taxman, smelling money, asks for his due when leave is encashed.

Tax — even and odd

If you encash leave while continuing in the job, say, at the end of each year, the amount is fully taxable at slab rates evenly across employee categories — government and non-government. On the other hand, if the leave encashment amount is given to nominees or legal heirs on the death of the employee while in service, the amount is fully exempt from tax across employee categories.

The tax treatment becomes differentiated and complicated when it comes to leave encashment on retirement or resignation. Here, government employees pay no tax on the leave encashment amount. This can mean big savings, given that leave encashment amounts after long service can run into lakhs.

No such luck of full tax exemption for non-government employees when they retire or resign. They too get a tax break under Section 10(10AA) of the Income Tax Act but it is limited to the least of the following: a) amount actually received as leave encashment b) amount prescribed by the government — ₹3 lakh c) 10 months average salary based on Basic and Dearness Allowance in the 10 months before leaving the job, and d) cash equivalent of the employee’s leave balance, subject to a maximum of 30 days for each completed year of service.

Say, a non-government employee gets 45 days leave for each year of service according to her employment terms. Over 30 years of employment, she would have earned 1,350 days of leave, of which she used 780 days; so the leave balance is 570 days (19 months).

Say, the employer gives her ₹8 lakh as leave encashment. For tax exemption calculation, the earned leave will be restricted to 30 days for each year of service; that’s 900 days. Deduct the 780 days leave taken and the leave balance will be just 120 days (four months).

If the average monthly Basic plus Dearness Allowance in the 10 months before leaving service is ₹40,000, the tax exemption will be the least of the following amounts: 1) ₹8 lakh (amount received) 2) ₹3 lakh (amount prescribed by government) 3) ₹4 lakh (10 months average monthly salary of ₹40,000) 4) ₹1,60,000 (four months * average monthly salary). So, of the ₹8 lakh received as leave encashment, just ₹1,60,000 will be exempt from tax.

The take-home amount will be just about ₹6 lakh (for those in the 30 per cent tax slab) with the taxman taking away ₹2 lakh.

Limit across employers

Also, note that the tax exemption limit (prescribed by the government) of ₹3 lakh for non-government employees is an aggregate sum across employers. So, if you have already claimed ₹2 lakh as tax exemption on leave encashment when you left the services of an employer, you can claim only the remaining ₹1 lakh when you resign or retire from future employments.

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