Section 10 of the Income Tax Act, 1961 (Act) vide its clause (10AA) provides for income tax exemption from leave encashment or leave salary received at the time of retirement, resignation or otherwise termination of employment. The exemption under section 10(10AA) from encashment of leave salary can be availed under the given circumstances discussed in this article.
Introduction on Leave Salary
In every organization, employees are allowed to take leave during their service by employers. Such employees may avail the leave or may accumulate the leave, if allowed. Almost all organizations allow their employees to encash the unutilized leave period either at the end of the financial year or at the time of retirement or leaving the job. The employee may not avail such leave but encash it in future during the term of employment. In some cases, unutilized leave period may lapse for which no encashment is permitted by the employer. The taxation of leave salary depends upon how and when the leave encashment amount is received by the employee.
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.
Leave Salary is taxable as ‘Salary’ income
Any payment received by an employee in respect of any period of leave not availed of by him from the employer is chargeable to tax as ‘Salary’ income under section 17(1)(va).
Sub-clause (va) [also corresponding exemption clause (10AA)] was inserted in section 17(1) by the Taxation Laws (Amendment) Act, 1984, w.e.f. 1-4-1978 to provide that any payment received by an employee in respect of any period of leave not availed of by him shall be regarded as “salary”.
Similarly, another amendment was made in section 10(10AA) of the Act to clarify that the exemption from leave encashment shall be allowed only where the payment is received by the employee on his retirement, whether on superannuation or otherwise.
The combined effect of the two aforesaid amendments will be that payments received by an employee in respect of any period of earned leave not availed of by him will be exempt from income tax only in cases where such payments are received on retirement and subject to the fulfilment of the other conditions laid down in section 10(10AA) of the Act.
In this context, it should be noticed that the exemption from leave salary is given in section 10 of the Act. Hence, if a receipt is not chargeable under section 17 it is unnecessary to examine section 10 as it cannot be decided with reference to the said section. If any, receipt does not fall within the ambit of section 17 and is also included in the exemptible limit under section 10, it shows that the Legislature by way of abandoned precautions refers to them in section 10 - Rani Amrit Kunwar vs. CIT (1946) 14 ITR 561 (All.).
Bare text of the exemption provision related to leave encashment
Section 10(10AA) which provides the exemption from leave salary encashment reads as follows:
10. In computing the total income of a previous year of any person, any income falling within any of the following clauses shall not be included—
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(10AA) (i) any payment received by an employee of the Central Government or a State Government as the cash equivalent of the leave salary in respect of the period of earned leave at his credit at the time of his retirement whether on superannuation or otherwise ;
(ii) 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 ;
Further, Explanation under section 10(10) clarifies that for the purpose of clause (10AA) "salary" shall have the same meaning as assigned to it in clause (h) of rule 2 of Part A of the Fourth Schedule. The definition of ‘salary is given in the Explanation at the end of clause (10) for purposes of both clauses (10) and (10AA).
Accordingly, ‘salary’ includes dearness allowance, if the terms of employment so provide, but excludes all other allowances and perquisites.
Analysis of Section 10(10AA) to claim exemption
Essential ingredients of section 10(10AA) to claim the exemption from leave salary encashment are analysed forthwith.
Clause (10AA), which exempts from tax the cash equivalent of leave salary in respect of earned leave to the credit of an employee, received by him at the time of retirement covers two classes of employees as follows:
(i) Sub-clause (i) deals with employees of the Central Government or a State Government.
(ii) Sub-clause (ii) deals with employees other than employees of the Central Government or a State Government. It includes private-sector employees, employees of PSUs, Banks, Corporations, etc.
When an employee accumulates his earned leave and encashes them on retirement, whether on superannuation or otherwise, an exemption is allowed from such encashment of leave salary in the following manner-
Circumstances under when leave salary is fully exempt from tax
Leave Salary received by retiring government employees is fully exempt from tax: Any amount received by a central government or a state government employee towards encashment of leave salary from the employer at the time of retirement is exempt from tax under section 10(10AA)(i).
The payment of leave encashment to the employee by the employer shall be in respect of any period of leave not availed of by him and remain unutilized at the time of retirement.
Thus, payments received by an employee in respect of any period of leave not availed of by him will be exempt from income tax only in cases where such payments are received on retirement. Hence, it follows that payments received by an employee in respect of any unutilized period of leave during the continuation of employment or while in service is not exempt from tax and is fully taxable u/s 17(1)(va).
Circumstances under when leave salary is not fully exempt from tax or is partially taxable
Under sub-clause (ii) of clause (10AA), any payment received by an employee, other than an employee of the Central Government or a State Government (non-government employees), is exempt from tax subject to certain conditions.
In the case of other employees (non-government employees), the exemption under section 10(10AA)(ii) will be determined with reference to the leave to their credit at the time of retirement on superannuation, or otherwise, subject to a maximum of cash equivalent of leave salary of ten months' leave calculated on the basis of average salary drawn during the 10 months immediately preceding his retirement. The entitlement of earned leave cannot exceed 30 days for every year of actual service rendered. This exemption will be further limited to the maximum amount specified by the Government of India.
The maximum limits of exemption are not specified in the sub-clause. Instead, it is provided that the limit may be specified by the Central Government by way of notification in the Official Gazette, having regard to the limit applicable to the Central Government employees.
The government vide Notification No. 123/2002 in S.O. 588(E), dated 31-5-2002 specified the limit of Rs. 3,00,000 under section 10(10AA)(ii) in relation to such employees who retire, whether on superannuation or otherwise, after 1-4-1998.
Prior to an amendment by the Direct Tax Laws (Amendment) Act, 1987, the maximum amount of exemption under clause (10AA)(ii) was specified in the clause itself. Hence, an amendment in the Income-tax Act was required every time whenever the limit was proposed to be enhanced. After this amendment which requires notifying the maximum amount of exemption, it would not be necessary to make frequent changes in the Income-tax Act every time the monetary limit is to be changed as and when the maximum amount of allowable leave encashment is changed in the case of Central Government employees.
Note: CBDT issued 10 gazette notification from 1982 to 2002 specifying the maximum amount receivable by a government employee so as the exemption limit under section 10(10AA)(ii). Since then no notification has been issued for the last 19 years.
The essence of the provisions related to the issue of notification by the government is that the government will notify the maximum amount of exemption limit for non-government employees from the leave encashment salary received by them. The government is required to notify that amount of exemption limit which is earned by the government employees. In other words, if a non-government employee receives more than leave encashment amount compared to government employees then such excess will be chargeable to tax.
Thus the benchmark for setting the amount of exemption limit is the leave salary amount received by the government employees. Among the government employees, the highest pay scale is of a Cabinet Secretary.
The exemption limit for non-government employees is linked to the leave salary receivable by him. Therefore, whenever there is an increase in the leave salary entitlement of the Cabinet Secretary, the government issues a notification upto that limit for other than government employees. The Cabinet Secretary is getting the highest salary in Government.
In 2002 when the leave salary entitlement of a Cabinet Secretary was around Rs. 3,00,000, the exemption limit for sub-clause (ii) was notified at Rs. 3,00,000. Since then there has been a manifold increase in the leave salary entitlement of a Cabinet Secretary, however, unfortunately, no notification has been issued by the government to raise the exemption limit from Rs. 3 Lakh. This goes against the letter and spirit of the main provisions as contained in section 10(10AA)(ii).
Thus the amount of exemption for non-government employees shall be equal to the amount of exemption as available to a government employee.
This, as per the provision, exemption for non-government employees for section 10(10AA)(ii) is equal to the limit of exemption (leave salary encashment entitlement) of that of a government employee.
It should be noted that the Gazette Notification is only a medium or a tool to inform the limit of the government employees. The importance of gazette notification is not more than that.
The gazette notification is not about prescribing the maximum amount of exemption limit for non-government employees. The maximum amount of exemption limit for non-government employees is already stated in above provision sub-clause (ii) of clause (10AA) of section 10. This exemption limit for non-government employees is equal to the amount of leave salary encashment receivable by government employees. The Central Government only publishes this amount of leave salary encashment receivable by government employees in the Gazette Notification for providing exemption to non-government employees.
It is indeed an unfortunate situation that CBDT has not issued any gazette notification in the last 19 years to specify the higher limit of leave salary encashment entitlement of the Cabinet Secretary so that leave encashment for non-government employees remains exempt upto that level. On plain readings of the provisions, it is clear that CBDT is bound to issue a gazette notification whenever there is any changes in the leave encashment of a government employee. The basis of determining the leave encashment receivable of a government employee used in the past is that of the Cabinet Secretary since he is the highest-paid government employee.
Therefore, a question may arise whether a higher exemption can be claimed by a non-government employee if there is no gazette notification despite the increase in the leave encashment entitlement of the Cabinet Secretary since 2002.
Section 10(10AA)(ii) prescribed that maximum amount of exemption that can be allowed to a non-government employee from leave salary received at the time of retirement whether on superannuation or otherwise is the leave encashment entitlement shall be required to be notified having regard to the leave encashment entitlement of government employees. Hence, in the opinion of the Author, an increase in the limit of leave encashment entitlement of a government employee is not sufficient, the same is also required to be published in the official gazette. Under these circumstances, the higher exemption can be claimed by non-government employees.
Consider a case of an employee of a Bank or LIC or a PSU where the pay scale is almost equal to central government employees. If an employee from these organizations receives leave salary at the time of retirement whether on superannuation or otherwise then in most of the cases they are receiving the same amount of leave salary but getting exemption upto Rs. 3,00,000 only whereas the government employee enjoys exemption from the entire amount of leave salary.
For example, if a Bank or a PSU employee receives Rs. 10 Lakh as leave salary on his retirement then he will get tax exemption upto Rs. 3,00,000 only and is required to pay tax on the remaining Rs. 7,00,000. Whereas in case of the government employee, the entire Rs. 10 Lakh will be exempt from tax as per the provisions of section 10(10AA)(i).
However, the provisions of section 10(10AA)(ii) state that the Bank employee is also entitled to exemption from leave salary upto Rs. 10,00,000 provided CBDT notifies Rs. 10 Lakh in a gazette notification.
In this context it should be noted that Hon’ble Delhi High Court has issued a notice to the government while deciding the case of Kamal Kumar Kalia & Ors vs. Union of India & Ors. in W.P.(C) No. 11846/2019 moved by some retired bank employees to file its response on the matter of non-issuance of gazette notification to enhance the limit for section 10(10AA)(ii) considering the fact that the last drawn salaries have increased manifold since time and notification issued under Clause (ii) of Section 10 (10AA) was lastly issued. The matter is pending before the Court as on the date of publishing this article.
Circumstances under when leave salary is not exempt from tax and is fully taxable
Under section 10(10AA), payments received by an employee in respect of the unutilized period of leave not availed of by him will be exempt from income tax only in cases where such payments are received on retirement. Hence, it follows that payments received by an employee in respect of any unutilized period of leave during the continuation of employment or while in service is not exempt from tax and is fully taxable u/s 17(1)(va).
The amount of leave salary encashment received by an employee while in service shall be fully taxable under the head ‘salary’ by virtue of express provisions contained in section 17(1)(va).
There are many companies which allow encashment of unutilized leave period by the employees at the end of every financial year. In these cases since the employees are continuing in the service, the receipt of such leave encashment shall be fully taxable as 'salary' income under section 17(1)(va). No exemption from such receipt of income is allowable under clause (10AA).
In this context, the Allahabad High Court in the case of CIT vs. Ved Prakash Gupta had adjudicated a controversy which centered round as to whether the sum received by an employee who continues to be in employment towards the leave encashment shall be includable in salary or not.
The Tribunal disagreeing with the Income Tax officer held that the words "or otherwise in Section 10(10AA) of the Act clearly indicates that the exemption is to be given to the assessee in the cases as and when there is a payment to the assessee in lieu of leave encashment and these words "or otherwise" do not restrict the purview of exemption to the retiring employee only."
Overruling the decision of the Tribunal, the High Court held as follows:
“The interpretation put by the Tribunal on Ihe "or otherwise" does not appear to be legally sound. The words "or otherwise" are of very wide amplitude. These words shall draw the restricted meaning qua the immediately preceding word "superannuation". The superannuation is of an employee's severance of relationship of contrast of employment in between employer and employee. After attaining a specified age, an employee ceases to an employee ipso facto in pursuance of terms and conditions governing the employment. The phrase "or otherwise" will cover only such an eventuality when there is severance of relationship of employer and employee and contract employment. To put it differently the phrase "or otherwise" will not cover such cases where there is no severance of relationship of employer and employee and the assessee continues to be under the employment of the same employer and receiving the leave encashment. This interpretation is in consonance of the legislative history of| the section as well as it also manifests the intention of the legislature to give a limited benefit to an employee with respect to the income received by the employee at the time of his retirement or superannuation or severance of relationship.”
A similar decision is rendered in the cases of CIT vs. Vijai Pal Singh (2005) 144 Taxman 504 (All) and CIT vs. Ram Rattan Lal Verma (2005) 145 Taxman 256 (All) by the Allahabad High Court.
Relief u/s 89 from encashment of Leave Salary which is fully taxable
In cases where unutilized earned leave for the year is paid to the employee at the end of the year then such encashment of earned leave is not subject to relief u/s 89. The basic objective of Section 89 is to give income-tax relief to a person who receives arrears or advance of salary of more than one financial year in a particular year.
Where the employee encashes his accumulated earned leave balance in his credit then encashment of such accumulated earned leave during employment is subject to tax without any exemption u/s 10(10AA) and is eligible for relief under section 89.
Section 89 provides for relief to an assessee when salary, etc., is paid in arrears or in advance or if he receives in one financial year salary for more than 12 months and therefore, his income is assessed at a rate higher than at which it would have otherwise been assessed. This relief is granted by the Income-tax Officer on an application made to him on this behalf.
Since encashment of accumulated earned leave salary pertains to more than one financial year, the relief u/s 89 is available from such income.
CBDT has already clarified that relief under section 89(1) read with rule 21A of the Income-tax Rules, 1962 would be admissible in respect of encashment of leave salary by an employee when in service. The encashment of leave salary on retirement whether on superannuation or otherwise has already been exempted, by insertion of clause (10AA) in section 10. [Circular No. 431 [F. No. 174/43/82-IT (A-II)], dated 12-9-1985]
How to Calculate the Relief u/s 89 from the Leave Encashment
When any individual receives any salary in arrears or in advance or receives profit in lieu of salary, he can claim relief for payment of tax on such salary under section 89 as under:
1. Calculate the tax payable on the total income of the relevant previous year in which the leave salary is received including the leave salary.
2. Calculate the tax payable on the total income of the relevant previous year in which the leave salary is received excluding the leave salary.
3. Find the difference between the tax at Step 1 and Step 2;
4. Compute the tax on the total income after including the leave salary in the year to which such leave salary relates.
5. Compute the tax on the total income after excluding the leave salary in the year to which such leave salary relates.
6. Find the difference between tax at step 4 and step 5
7. The excess of tax at step 3 over tax computed at step 6 is the amount of relief admissible under section 89.
No relief is, however, admissible if tax computed at step 3 is less than step 6. In such a case, the employee need not apply for relief.
Meaning of ‘government employees’ for exemption u/s 10(10AA)
The provisions of section 10(10AA) provide for exemption of leave encashment from tax. If an employee is a government employee the leave encashment amount/income earned by him will be fully exempt from tax.
In Kamal Kumar Kalia vs. UOI (2020) 268 Taxman 398 (Delhi) (HC): [W.P.(C) 11846/2019 decided on 08.11.2019], the Delhi High Court has held that retired employees of PSUs and nationalised bank cannot be treated as Government employees and hence not entitled to get full tax exemption on leave encashment after retirement/superannuation u/s10(10AA).
The Court held that merely because Public Sector Undertaking and Nationalised Banks are considered as ‘State’ under article 12 of the Constitution of India for the purpose of entertainment of proceedings under Article 226 of the Constitution and for enforcement of fundamental right under the Constitution, it does not follow that the employees of such Public Sector Undertaking, Nationalised Banks or other institutions which are classified as ‘State’ assume the status of Central Government and State Government employees.
Meaning of ‘Retirement’ for Leave Encashment Exemption
The term ‘retirement' is not defined in the income tax Act. Hence, a question arises whether retirement includes ‘resignation’ for the purpose of claiming the exemption u/s 10(10AA).
It is the stand of the income-tax department the benefit of section 10(10AA) of the Act is available only in cases where the leave encashment amount is received by the employee at the time of his retirement and not on resignation from the employment.
The issue of whether the term ‘retirement’ includes ‘resignation’ for the purposes of the exemption under section 10(10AA) have been scrutinized in certain judicial precedents.
The case reported in CIT vs. R.J.Shahney [1986] 159 ITR 160 (Mad) deals with the applicability of section 10(10AA) relating to exemption of encashment of leave salary at the time of resignation.
As per judgments of the Madras High Court in the cases of CIT vs. J. Visalakshi [1994] 206 ITR 531 and R. J. Shahney (supra) "retirement" includes "resignation".
The phrase retirement on superannuation or otherwise has caused a lot of confusion and consequent litigations. The Officers of the Income Tax Department are known to have taken a stand that leave encashment is exempt only if it is received at the time of retirement.
In respect of exemption from leave encashment for non-government employees, Hon’ble Bombay High Court in the case of CIT vs. D.P. Malhotra (1998) 229 ITR 394 (Bom) has observed that “both "retirement" and "resignation" result in the conclusion of the service career. In fact resignation from service is also one of the modes of retirement from service. Resignation is a voluntary act of the employee to retire from service. Once an employee resigns, his service stands terminated from the date on which his letter of resignation is accepted by the appropriate authority, unless there is any law or statutory Rule governing the conditions of service to the contrary. In other words, on acceptance of resignation, the employee stands retired from service. The word "retirement" has not been used in Clause (10AA) in the restricted sense to mean "retirement on superannuation". On the other hand, it is clear from the language of Clause (10AA) itself that it has been used in the widest possible terms to mean and include all cases of retirement, whether on superannuation or otherwise. What is relevant is "retirement" - how it took place is immaterial for the purpose of this Clause. It is, therefore, clear that if on retirement, even on resignation by the employee, an employee gets by way of leave encashment any amount, Clause (10AA) would apply and the assessee will be entitled to the benefit of the said Clause to the extent mentioned therein.” (emphasis added)
Finally, the Court decided the appeal in favour of the assessee holding that if there is any voluntary retirement from service the provisions of section 10(10AA) would apply.
Hence, as per the decisions given by the Madras High Court in the case of R. J. Shahney’s case and by the Bombay High Court in D.P. Malhotra’s case, leave encashed at the time of resignation is also exempted from tax under section 10(10AA).
Further, their Lordships in the case of State Bank of India vs. A.N. Gupta [Civil Appeal No. 9943 of 1983 decided on 30.09.1997] have observed that it cannot be said that an employee retires only on superannuation and there is no other circumstance under which an employee can retire. Retirement on superannuation is not the only mode of retirement known to service jurisprudence. There can be other types of retirements like premature retirement, either compulsory or voluntary. Please note that this was not a case of income tax exemption on leave encashment but a case in the context of withholding of pension and provident fund under service rules. But still have relevance in interpreting the term retirement for section 10(10AA).
The view that retirement includes resignation further fortifies from the fact that the first and second proviso to sub-clause (ii) speaks about exemption in cases where leave salary is received from more than one employer. Thus, the Act itself recognizes resignation as a mode of retirement.
Unfortunately, some employers and even income tax officers adopt contrary views.
It is expected that CBDT shall clarify or define the meaning of ‘or otherwise’ unambiguously, else this expression will continue to be interpreted differently by different persons.
Termination of employment: If an employee is terminated from the employment then such termination does not amount to ‘retirement’ though termination brings severance from services. Hence, the expression ‘or otherwise’ will not include termination and any leave salary received on termination of employment will be fully chargeable to tax. Thus, no exemption from leave encashment will be available in case of termination of employment. A contrary view cannot be ruled out.
Classification of government and non-government employees for leave salary exemption is constitutionally valid
The Madras High Court in the case of K. Gopalakrishnan vs. CBDT (1994) 206 ITR 183 (Mad.) has categorically held that section 10(10AA) of the Act is not unconstitutional and void. The classification found in the sections is valid and based on sound reasoning.
It was further observed by their Lordships that no doubt a differentiation is made between the employees of the Central and State governments on the one hand and the other employees on the other in section 10(10AA) of the Act. When full exemption is provided in the sections to retirement gratuity and encashment of earned leave by the Government employees, the exemption in the case of other employees had been restricted to a limit calculated in accordance with the provisions in the section on the basis of the salary of those employees. But, that would not by itself make the sections discriminatory or violative of article 14 of the Constitution of India.
Exemption from leave encashment from more than one employer
The first proviso to section 10(10AA)(ii) states that where leave salary is received from more than one employer in the same previous year, the aggregate amount of exemption shall not exceed Rs. 3,00,000.
The maximum amount of exemption from leave salary is Rs. 3,00,000 for non-government employees. This limit is applicable irrespective of receipt of leave salary from any number of employers. Thus, if in a previous year, an employee receives a leave salary from more than one employer, he will get a total exemption of Rs. 3,00,000 in that previous year for all the employers.
Maximum Amount of Exemption u/s 10(10AA)(ii) is for the entire service career
The second proviso to section 10(10AA)(ii) states that where any leave encashment was received in any one or more earlier previous year also and the whole or any part of the whole or any part of the leave encashment amount was not included in the total income of the employee of such previous year or years, the amount exempt from income-tax U/S 10(10AA) shall not exceed the limits so specified as reduced by the amount or the aggregate amount, not included in the total income of such previous year or previous years.
In other words, it states that if the benefit of exemption u/s 10(10AA)(ii) is already availed by the employee in earlier previous year(s), then the exemption so allowed earlier will also be considered while computing the maximum amount of exemption u/s 10(10AA)(ii) in the current previous year.
In simple words, the exemption of Rs. 3,00,000 is applicable for an employee for his whole service/employment career. The exemption is lifetime limit for availing the exemption u/s 10(10AA)(ii) whether from one employer or from more than one employer.
Computation of Leave Salary Encashment Exemption under section 10(10AA)(i)/(ii)
The entire amount of leave encashment of accumulated earned leave at the time of retirement whether on superannuation or otherwise received by a government employee is fully exempt from tax under section 10(10AA)(i)..
However, leave encashment of accumulated earned leave at the time of retirement or resignation received by a non-government employee is exempt from tax to a certain limit under section 10(10AA)(ii). In such a case, the least of the following shall be exempt-
Notes:
1. Leave salary actually received by the employee from the employer on retirement whether on superannuation or on retirement.
2. ‘Average Salary’ is calculated on the basis of the average salary drawn by the employee during the period of 10 months immediately preceding his retirement whether on superannuation or otherwise. To put it simply, it refers to the last 10 months average salary before retirement.
For example, if an employee resigns on 20.11.2020, then last 10 months salary shall be for the period from 21st January 2020 to 20th Nov., 2020.
The term ‘month’ is not defined therefore as per General Clauses Act it shall be taken as British Calendar Month.
3. An employee shall be entitled to claim exemption for unavailed earned leave to be calculated @ 30 days of earned leave for every year of actual service rendered by him as an employee of the employer from whose service he has retired.
In other words, an employee shall be entitled for 30 days of earned leave for every completed year of service. Any fraction of a year shall be ignored. Thus if the service period is 10 years and 7 months, it shall be taken as 10 years.
Total leave availed by the employee is required to be deducted to compute the unavailed earned leave or earned leave balance which is eligible for exemption.
The period of such leave is valued at the salary of the employee. ‘Salary’ for the purpose of computation of exemption from leave encashment u/s 10(10AA) means basic salary plus dearness allowance. It also includes commission based on a fixed percentage of turnover achieved by the employee. However, any other allowance received is not to be included in the computation of salary.
Illustration: If an employee works for 10 years and 7 months then his earned leave entitlement for exemption is 10 years x 30 days = 300 days.
In his service period, he has taken leave of 180 days and is paid for unavailed earned leave balance of 120 days (300-180).
If his monthly basic salary plus D.A. is Rs. 30,000 then his Leave Salary for unutilized earned leave comes to Rs. 1,20,000 (Rs. 30,000 x 4 months]. Hence for serial (c) in the above table, it is Rs. 1,20,000/-.
4. The amount specified by the government is Rs. 3,00,000. Hence, the amount of exemption under section 10(10AA)(ii) cannot exceed Rs. 3,00,000. It should be noted that this limit of Rs. 3,00,000 shall be available for the entire service life whether for one employer or more than one employer and in one or more previous years.
Exemption from leave salary in case of contract employees
Though employer-employee relationships may exist in the case of contractual employment, the ending of such a contract amounts to termination of employment which cannot be equated with retirement or resignation. Hence no exemption from leave encashment received from the employer by the employee is available for termination of employment under a contract. Such receipt of leave encashment shall be taxable.
Leave Salary Exemption paid to legal heirs of the deceased employee
Where an employee dies while in service, the employer pays the leave salary in respect of earned leave standing to the credit of the employee to the legal heirs of the employee.
The Board vide its Letter No. 35/1/65-IT(B), dated 5-11-1965 has clarified that it is not a payment from the employer to the employee and hence cannot be taxed as salary. It is an ex gratia payment on compassionate grounds in the nature of gift. Thus, the payment is not in the nature of salary. This payment is only by way of financial benefit to the family of the deceased employee, which would not have been due or paid had the employee been alive. Therefore, payment of such leave salary to the legal heirs of the deceased employee cannot be taxed as salary and the amount will not be liable to income-tax.
Taxability of leave encashment on receipt basis or accrual basis
As per section 15, salary income is chargeable to tax on receipt basis or accrual basis whichever happens earlier. Normally, salary is received after it becomes due only. However, in some cases, salary is paid in advance also.
Section 17(1) defines the meaning of the term ‘salary’ in an inclusive manner to include any payment received by an employee in respect of any period of leave not availed of by him under sub-clause (va).
In the context of leave salary, one should note that the same shall be treated as income of that previous year in which leave salary is due to the employee. Unutilized earned leave at the end of every year which is carried forward to next year which may be utilized by the employee or may be further accumulated. Therefore simply accumulation does not give any right to the employee to receive the leave salary. However, if the unutilized earned leave is given encashment to the employee by the employer instead of carry forward then such leave encashment shall be treated as income in the previous year in which it is accrued and due to the employee and not in the previous year in which it is paid to the employee.
In case leave is encashable at the time of retirement or resignation by the employee the same is taxable in the year in which the employee is retired or resigned and not in the previous year in which leave salary is paid.
Further, it should be noted that section 10(10AA) states that any payment received as leave salary shall be exempt from tax. This does not mean that exemption will not be available if leave salary is taxed on due basis. However, it should be remembered that if an income is taxed on due basis, it cannot be taxed again on receipt basis.
TDS on Leave Salary
Leave Salary is not a separate component of income but falls within the scope of salary income. By virtue of section 17(1)(va), leave salary is first included in the salary income of the employee. Thereafter, in case the leave encashment is eligible for exemption under section 10(10AA)(i) the same will be given the exemption. If the amount of leave encashment is partly exempt under section 10(10AA)(ii) then the amount not so exempt would be added to the income from salaries and tax would be deducted in respect thereof accordingly.
Therefore, the tax thereon will be deducted from the total income of the employee including the leave salary in accordance with the provisions of section 192 of the Act.
Leave Salary received during employment is not eligible for exemption and is always included in the total income of the employee and tax is deducted accordingly therefrom by the employer.
Leave Exemption for employees absorbed by BSNL from DoT
BSNL, vide its letter no. 1001-04/2011-12/Taxation/BSNL/ LE/196 dated 04.05.2012 already issued instruction that-
1. Encashment of Leave Credit of Government Service at the time of permanent absorption into BSNL from DOT that is on 01.10.2000 is eligible for full exemption under section 10(10AA)(i) of Income Tax Act, 1961
2. Leave salary of pensioner after absorption in BSNL from 01.10.2000 is exempted from income tax subject to maximum upto Rs 3,00,000 and remaining amount is taxable.
Please note that the above instruction is issued by the BSNL and not by the CBDT or Finance Ministry in this regard.
Summary of Relevant Points regarding Exemption from income tax on Leave Encashment under section 10(10AA)
‘Salary’ for the purpose of computation of exemption from leave encashment u/s 10(10AA) means basic salary plus dearness allowance. It also includes commission based on a fixed percentage of turnover achieved by the employee. However, any other allowance received is not to be included in the computation of salary.
‘Average Salary’ is to be computed on the basis of the average salary drawn by the employee during the period of 10 months immediately preceding his retirement.
An employee is entitled to claim exemption for unutilized balance of his earned leave to be computed @ 30 days for every complete year of service which is reduced by leave availed by the employee. The value of such leave balance computed by multiplying the days with the salary.
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.
Leave encashment received by the family members/legal heirs after the death of an employee is not chargeable to tax in the hands of the family member.
The retirement of employees may be of various kinds. It may be on superannuation or voluntary such as resignation. Retirement includes resignation for section 10(10AA).
Relief under section 89 is available from encashment of leave salary.
Leave encashment is fully exempt in case of government employees. For non-government employees, leave encashment is exempt upto Rs. 3,00,000.
CBDT circulars on leave salary exemption
624. Relief in case of encashment of leave salary by an employee while in service - Whether admissible
1. Section 89(1) provides for relief to an assessee when salary, etc., is paid in arrears or in advance or if he receives in one financial year salary for more than 12 months or a payment which under the provisions of clause (3) of section 17 is a profit in lieu of salary and therefore, his income is assessed at a rate higher than at which it would have otherwise been assessed. This relief is granted by the Income-tax Officer on an application made to him in this behalf.
2. The question of admissibility of relief under section 89(1) in respect of amounts received on encashment of leave salary while in service was considered by the Board. The Board are advised that relief under section 89(1) read with rule 21A of the Income-tax Rules would be admissible in respect of encashment of leave salary by an employee when in service. The encashment of leave salary on retirement whether on superannuation or otherwise has already been exempted, by insertion of clause (10AA) in section 10, by the Finance Act, 1982 with effect from 1-4-1978.
Circular: No. 431 [F. No. 174/43/82-IT (A-II)], dated 12-9-1985.
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183. Cash equivalent of leave salary payable to legal heirs on the death of Government/non-Govemment employees - Whether taxable under the head "Salaries"
CLARIFICATION 1
1. In terms of para 1(iv) of O.M. No. 16(2)-E-IV(A)/73, dated 9-1-1974 issued by the Ministry of Finance, Department of Expenditure, the family of a Government servant, who dies in harness, is entitled to receive the cash equivalent of the leave salary that the deceased Government employee would have got if he had gone on earned leave. The amount is payable on the date immediately following the date of death, subject to a maximum leave salary for 120 days and subject to the reduction envisaged in rule 40(7)(a) of the Central Civil Service (Leave) Rules, 1972. The question whether the amount received by the family in these circumstances is taxable has been considered.
2. The Board have been advised that this receipt in the hands of the family is not in the nature of one from an employer to an employee. The deceased had no right or interest in this receipt. This payment is only by way of financial benefit to the family of the deceased Government servant, which would not have been due or paid had the Government servant been alive. In view thereof the amount will not be liable to income-tax.
Circular: No. 309 [F. No. 200/125/79-IT(A-I)], dated 3-7-1981.
CLARIFICATION 2
The leave salary paid to the legal heirs of the deceased employee in respect of privilege leave standing to the credit of such employee at the time of his/her death is not taxable as salary.
For being taxable as salary, the payment must be due from an employer to the assessee. If the deceased officer is regarded as the assessee in respect of the proposed payment, then the amount was not due to the assessee. Firstly, this is not a payment which was due to be paid to him after his death as a matter of contractual right. Secondly, even before his death, the payment was not due to him unless and until the leave was actually taken by him.
If the legal representative of the deceased is to be taken to be the assessee, then the amount/proposed to be paid is certainly not due to him. It is an ex gratia payment on compassionate grounds in the nature of gift. Thus, the payment is not in the nature of salary.
Letter: No. 35/1/65-IT(B), dated 5-11-1965.
JUDICIAL ANALYSIS
REFERRED TO IN - The above letter was referred to in ACED v. Durga Devi Lara [1984] Taxation 75(6)-118 (Hyd. - Trib.). This was a case under the Estate Duty Act, and the question involved was whether salary equivalent of leave not availed by the deceased which was paid to the legal heirs was ‘property passing on death’ under section 5 of that Act. The Tribunal observed :
"The categorical statements are that the amount was not due to the deceased unless he took leave which he had not taken in the present case. It was also not a payment which was due to be paid after his death as a matter of contractual right. Therefore, the deceased was not possessed of any property. This is a case where property, viz., monetary equivalent of leave salary, was not in existence at a time before the death of the deceased. This being so, the question of any property passing on his death did not arise. In the Board’s circular it is also categorically stated that the payment was an ex gratia payment on compassionate grounds in the nature of a gift to the legal heirs. The learned departmental representative sought to submit that the amount may be ex gratia as far as the legal heirs were concerned but it did not imply that it partook of the same nature as far as the deceased was concerned. If the amount was due to the deceased, it could never be an ex gratia payment to the legal heirs, but it would be a legitimate due. So if the payment is ex gratia to the legal heirs, certainly it was not an amount due to the deceased.
Having come to the conclusion that there was no property of the deceased prior to his death, the question of any property passing on his death, albeit a moment after his death, insofar as leave salary in respect of leave not taken is concerned, did not arise. . . .". (pp. 120-121)
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34. Taxability of lump sum payment made gratuitously or by way of compensation or otherwise to widow/other legal heirs of an employee
1. Clarifications have been sought from the Central Board of Direct Taxes whether a lump sum payment made gratuitously or by way of compensation or otherwise, to the widow or other legal heirs of an employee, who dies while still in active service, is taxable as income under the Income-tax Act, 1961.
2. The issue has been examined by the Board and it is clarified that any such lump sum payment will not be taxable as income under the aforesaid Act.
Circular: No. 573, dated 21-8-1990.
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Notification No.: 123
Date of Issue: 31/5/2002
Section(s) Referred: S. 10(10aa)(ii)
Notification No. S.O. 588(E), dated 31st May, 2002.
In exercise of the powers conferred by sub-clause (ii) of clause (10AA) of section 10 of the Income-tax Act, 1961 (43 of 1961), the Central Government, having regard to the maximum amount receivable by its employees as cash equivalent of leave salary in respect of the period of earned leave at their credit at the time of their retirement, whether superannuation or otherwise, hereby specifies the amount of Rs. 3,00,000 (rupees three lakhs only) as the limit in relation to employees mentioned in that sub-clause who retire, whether on superannuation or otherwise, after the 1st day of April, 1998.
[Notification No. 123/2002/F. No. 200/23/98-ITA-I]
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2 Comments
Leave encashment received by legal heir. How/where to show this in legal heir's ITR. TDS has been deducted and can they claim full refund of TDS?
ReplyDeleteShow it as Exempt Income and claim TDS
Delete