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Is your leave encashment taxable or not?

Unutilized earned leave encashed by the Central / State Government employees, at the time of their retirement, is "entirely exempt" from tax.

Unfortunately, the non-Government employees are deprived of this bonanza. Only a part amount of their leave encashment is tax-free; with tax payable on the balance portion. (Why this discrimination?)

Moreover, the wording of the relevant tax law on leave encashment [Sec 10(10AA)] is somewhat ambivalent and contentious, leading to many disputes.

In this article we look at these two aspects
a. how much of the leave encashed is exempt from tax
b. the wording that often creates disagreement with the tax department

Leave encashment exempt from tax:
Minimum amount of the following will not be taxed
1. Amount actually received
2. Rs.3 lakhs
3. Unutilized earned leave * Average monthly salary
4. 10 months Average Salary

where
- Salary means only Basic + Dearness Allowance + Turnover based commission, if any
- Average Salary means average of last 10 months preceeding the retirement
- Earned leave entitlement should not be more than 30 days for each year of service with the particular employer

Any amount received, over and above this, would attract tax.

Note: The limit of Rs.3 lakhs is not for a particular employer, but for all employers put together from whom you receive leave encashment in your lifetime.

The contentious wording of the Sec 10(10AA)
Sec 10(10AA) states that the tax exemption applies when the leave encashment is received "at the time of retirement whether on superannuation or otherwise."

So, in two instances, the law is pretty clear
1. You can claim tax exemption on the amount received as leave encashment when you retire.
2. Leave encashed while still in service with the same employer is "fully" taxable as part of salary income. By the way, this applies to Government employees too.

But what if you resign from a company and take up another job:

This is where the words "or otherwise" create a confusion. Logically 'or otherwise' means that the exemption should be available even when the employee quits for any reason whatsoever other than retirement / superannuation.

The Income Tax Department, on the other hand, does not agree with this. This has led to many court cases. While many have ruled in favour of the employee and granted the necessary tax exemption, some courts have ruled in favour of the tax department. 

Many employers, therefore, play safe and deduct tax before paying out the encashed leave to the employees who "resign" from their service. The employee then has to apply and fight for a refund while filing his Income Tax Returns.

So, on a case to case basis, this conflict on leave encashment between the "resigning" employee and the Income Tax Department continues...

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