All Most all the private sector employees receives leave encashment component as part of their full and final settlement. But As per section 10(10AA) leave encashment is exempt from income tax to the extent allowed.
Leave Encashment – Government Employees:
As per section 10(10AA), leave encashment by a Government employee at the time of retirement (whether on superannuation or otherwise) is wholly exempt from tax.
Leave Encashment – Non Government Employees:
Any leave encashment received by non-government employees at the time of retirement/termination of employment, is exempt. The exemption will be least of the following:
1. Period of earned leave standing to the credit in the employee’s account at the time of retirement‽ × Average monthly salary∞
2. 10 months Average monthly salary∞
3. Rs. 3,00,000, Maximum amount as specified by the Government
4. Leave encashment actually received at the time of retirement.
‽ Leave credit to the account of the employee at the time of retirement should be restricted to 30 days per year of service if leave entitlement as per service rules exceeds 30 days per year of actual service.
∞Salary for the above purpose means average salary drawn in the past ten months immediately preceding the retirement (i.e., preceding the day of retirement) and will include basic salary, dearness allowance (if considered for computing all the retirement benefits) and commission based on fixed percentage of turnover achieved by the employee. Apart from the above items, salary for this purpose does not include any other allowances or perquisites.
Let us understand this with the help of example; Mr. Ram while retiring from Awadh Securities Pvt Ltd received leave encashment of Rs. 2,00,000. His period of leave standing to his account was 25 days, total years of service is 15 years. His Basic salary including DA was Rs. 25,000 per month. Let us now calculate the exemption amount;
1. Period of leave (15days*15years)/30 days x Average monthly salary (Rs. 25000) i.e. Rs. 1,87,500/-
2. 10 months average salary (Rs. 25,0000 * 10) i.e. Rs. 2,50,000
3. Rs. 3,00,000
4. Actual leave encashment received i.e. Rs. 2,00,000
So the maximum exemption will be Rs. 1,87,500. Taxable component of leave encashment will be Rs. 12,500.
ANY LEAVE ENCASHMENT RECEIVED DURING EMPLOYMENT IS FULLY TAXABLE IN THE HANDS OF THE RECEIVER.
Bare Act Reading
(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 ;