Tax treatment of leave salary received at retirement

Leave salary

An employee earns leave for each year of service. Leave not taken may be encashed: the employer pays its cash value, called leave salary. It is part of salary and taxable under the head Salaries; the exemption depends on when it is received and on who the employee is.

Leave encashed during service

Leave salary received while still in service is fully taxable, for every employee. Relief under section 157 (formerly section 89) is available only if the total income is assessed at a rate higher than it would otherwise have been because of one of the receipts that section lists (such as a sum in the nature of arrear or advance salary, or salary for more than twelve months in one tax year); the Assessing Officer then grants the prescribed relief on an application made by the employee. No relief is granted on income for which a deduction under section 19(1), Table: Sl. No. 12 has been claimed for that or any other tax year (section 157(2)).

Government employees (section 19(1), Table: Sl. No. 13)

Leave salary received by an employee of the Central or a State Government on retirement, on superannuation or otherwise, is wholly exempt.

Other employees: the least of four amounts (section 19(1), Table: Sl. No. 14; formerly section 10(10AA)(ii))

For any other employee (a company, firm or local authority employee) the deduction is the least of:

1. the cash equivalent of the leave at his credit at retirement, the earned leave being taken at not more than 30 days for every year of actual service;
2. 10 months' average salary: ten times the average monthly salary of the ten months immediately before retirement;
3. the limit notified by the Central Government, having regard to its own employees: ₹25,00,000; and
4. the leave salary actually received.

The amount received in excess of the least of these is taxable.

Meaning of salary and average salary (section 19(2)(b))

Salary means basic pay and dearness allowance if the terms of employment so provide (that is, where they make it part of retirement benefits); all other allowances and perquisites are left out. Commission fixed as a percentage of the turnover the employee achieves is neither an allowance nor a perquisite, and is generally treated as part of salary for this purpose, so it enters the ten-month average (and the cash equivalent of the leave) too. Average salary is the salary of the ten months immediately preceding the retirement, divided by ten.

Leave at credit = (leave allowed per year, but not more than 30 days) × completed years of service − leave taken or encashed during service. Its cash equivalent = leave at credit in days ÷ 30 × average monthly salary.

Other points

1. Limit for life. If leave salary was exempted earlier (from the same or another employer), the ₹25,00,000 limit is reduced by the amount already exempted (section 19(2)(f)).
2. Leave salary paid to legal heirs of an employee who dies in service is not taxable in their hands.
3. Received from more than one employer in the same year: the ₹25,00,000 limit is the total for all (section 19(2)(f)).

Illustration (our own)

Mr. Dev retires from a company on 31 December 2026 after 25 years and 4 months of service. His basic salary was ₹60,000 a month throughout the last ten months, and dearness allowance (part of retirement benefits) 20% of basic, so his average salary is ₹72,000. He earned 35 days' leave a year and took 300 days. He receives ₹12,00,000 as leave salary.

Leave at credit = 30 days (the ceiling, not 35) × 25 completed years − 300 = 450 days; cash equivalent = 450 ÷ 30 × ₹72,000 = ₹10,80,000. The deduction is the least of ₹10,80,000, ₹7,20,000 (10 × ₹72,000), ₹25,00,000 and ₹12,00,000, that is ₹7,20,000. Taxable leave salary = ₹12,00,000 − ₹7,20,000 = ₹4,80,000.