The employer is obligated to provide compensation for the unused paid leave, which is commonly referred to as leave encashment.
As per labour laws, every employed person is entitled to a minimum number of paid leaves annually. Nonetheless, an employee doesn’t need to utilise all of their allotted leave days within a single year. Several employers offer the option for employees to carry forward any unused paid leave to the subsequent year.
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Inevitably, this results in the employee having a remaining balance of unused leave when retiring or resigning from the company. As a result, the employer is obligated to provide compensation for the unused paid leave, which is commonly referred to as leave encashment.
Taxation of Leave Encashment:
Indeed, according to the law, leave encashment is subject to taxation. When an employee receives leave encashment during their employment, the amount is considered part of their “income from salary”. However, under Section 89 of the Income Tax Act, one can avail of certain tax benefits. To claim tax relief for leave encashment, it is necessary to complete Form 10E.
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Tax obligations when leaves are encashed while continuing employment:
The exemption for leave encashment is applicable only upon an employee’s resignation from the company. Therefore, if an employee decides to exchange their accumulated leaves for cash while remaining employed, the received amount is considered as part of their salary.
The entire sum earned is subject to taxation, and the employer will deduct the applicable taxes accordingly.
Tax obligation upon the encashment of leaves during resignation or retirement:
Government employees, who encash their leaves, are fully exempt from taxation, with no upper limit or restriction based on the number of days of leaves being encashed.
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This exemption is exclusive to government employees and does not apply to employees working in government companies or undertakings.
For employees in the private sector or government-owned companies, there is a limit of Rs three lakh. Leaves encashed up to this limit are exempt from taxation at the time of leaving the company.
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Budget 2023 Update:
The exemption limit for leave encashment for non-government employees was previously set at Rs. 3 lakh in 2002, but it has now been raised to Rs. 25 lakh due to the overall increase in salary income.
