Leave Encashment Calculation and Tax Exemption

1. Leave Encashment and Types of Leaves

Leave encashment is the amount the employer pays their employees for unutilized leaves. The accumulated leave balance can either be availed during the service period or as the full and final settlement by the employees at the time of their retirement or resignation. According to the Factories Act 1948, the leave encashment and bonus amount shall be settled by the 7th or 10th of the following month after the employee's resignation.

Types of leaves

Not all types of leaves can be encashed; one needs to know the types of leaves that can be encashed. To avail of any of these leaves, an employee must follow the guidelines stated in the company's leave policy and get prior approval from the employer. The different types of leaves generally provided in an Indian setup are given below.

1. Casual Leave: Casual leave is usually an organization's most availed leave type. Companies are free to determine the number of casual leaves employees can avail of. This must be specified in the company's leave policy, and every employee should have easy access to the policy document. Typically, casual leaves vary from a minimum of 7 to 10 days.
   
   
2. Privilege Leave: Privilege leave is the benefit that is generally extended to employees who have spent a considerable tenure with the company. Typically, this tenure can be decided between one to three years (differs from company to company). Employees usually take these leaves to prepare for exams for higher education, pursue their hobbies, spend more time with their families, etc. This benefit is provided to employees to encourage work-life balance in the workplace culture. Unutilized privilege leaves are eligible for leave encashment. Some companies cap the number of leaves that can be carried forward to the subsequent financial year and the maximum number of leaves that can be accumulated for encashment over the years of service. Privilege leave is calculated as 1.75 to 2.5 days for every 30 days of work.
    
3. Medical Leave: Employees availed of these leaves due to their medically unfavorable health conditions, making it difficult for them to carry out their work-related tasks partially or wholly. Once sanctioned by the employer, the pending medical leaves become eligible for leave encashment. The number of medical leaves allocated differs from company to company.
   
   
4. Sabbaticals: Sabbaticals are the benefit given to employees through leaves, typically for upskilling and pursuing higher education to advance their career. These are paid leaves and are a part of many organizations' learning and development policies.
   
   
5. Holiday Leaves: Holiday leaves are also paid leaves availed of by employees to go for more extended vacations, domestic or international, needing longer duration away from work. This benefit is provided to employees to encourage work-life balance in the workplace culture. Like all other types of leaves, these are paid and eligible for leave encashment.
   
   
6. Maternity Leave: Leave policies must constitute maternity leaves to encourage gender diversity in the organization. All female employees on confirmed employment who are not covered under the ESI Act, 1948, and have completed 80 days of continuous service with the organization are eligible for Maternity Leave. A woman employee can avail of 26 weeks of maternity leave with wages / Salaries (8 weeks of leaves preceding the expected delivery date, and the remaining 18 weeks can be availed post-delivery). Suppose a woman employee does not avail full eight weeks' leave preceding her delivery date. In that case, she can avail of that balance leave following her delivery, provided the total leave period, i.e., preceding and following the day of her delivery, does not exceed 26 weeks.  Maternity leaves can be extended for a period the company decides on a case-to-case basis. However, the extended leaves are unpaid. Maternity leaves are not considered for encashment.
    
   
7. Paternity Leave: In India, government workers are entitled to get 15 days of paternity leave. There is no formal policy dedicated to employees in the private sector. However, paternity leaves are gaining ground among companies in India, and some private sector companies have set out a progressive policy for paternity leaves.
   

2. Is Leave Encashment Taxable?

Balance leaves, subject to the maximum cap per the company's leave policy, can be encashed by employees during their service, at retirement, or when leaving the company. When encashed during the service period, it is fully taxable and part of the salary income. However, employees can claim an exemption under Section 10(10AA) of the Income Tax Act.

Conditions of Exemption from Tax

Employees can avail of partial or complete exemption for encashing leaves when leaving the company due to retirement or resignation. Some of the conditions for tax exemption are:

1. For Central or State Government employees, leave encashment at the time of resignation or retirement is fully exempt.

2. In the case of a legal heir receiving leave encashment on behalf of a deceased employee, the leave encashment amount is fully exempt.

3. Leave encashment received by non-government employees is exempt u/s 10(10AA) to the extent of the least of the following amounts:

4. • 1. Amount notified by the Government, which is ₹3,00,000.

     2. Actual leave encashment amount paid.

     3. Average salary for the last 10 months.

     4. Period of earned leave standing to the credit in the employee's account at the time of retirement* × Average salary for the last 10 months (subject to a maximum of 30 days leave per year).
        

The term 'salary' referred to above includes basic salary, dearness allowance, and commission based on a fixed percentage of turnover secured by employees. Average salary refers to 10 months' average wage immediately preceding retirement (i.e., the day of retirement and not the month of retirement).

If an employee receives leave encashment from more than one employer in the same financial year, the aggregate amount exempt from tax shall not exceed ₹300,000.

3. Calculation of Leave Encashment Amount

The formula for calculating the leave encashment is -
 [(Average Basic salary Average Dearness Allowance) / 30] * No. of Earned Leaves

Understanding the calculation of leave encashment amount with the help of the following illustrations.

Illustration:

Ms. X is retiring from the firm after 15 years of service to the company. She was entitled to 40 days of paid leave per annum, which makes it 600 days of leave during her 15 years of tenure in the company. Ms. X utilized 140 paid leaves during her service period and is left with 460 days of leave balance. 

If Ms. X is drawing an average salary of ₹42,000 per month (including dearness allowance) for the last 10 months from the date of retirement, her leave encashment amount will be:

= Salary per day * Number of earned leave (EL) balance

= ₹42,000/30 * 460               

= 1400 * 460

= ₹6,44,000

Therefore, Ms. X is entitled to receive an amount of ₹6,44,000 as leave encashment. 

4. Calculation of Exempt Amount

The exemption of Rupees three lakh notified by the Government is an aggregate exemption during an employee's lifetime. Hence the exempt leave encashment amount will be the lowest of the following calculated amounts.

The least of the following amount is considered for exemption from tax.

1. Amount notified by the government                      ₹3,00,000
2. Actual leave encashment                                        ₹6,44,000
3. Average salary of 10 months (42k*10)                    ₹4,20,000       
4. One day's salary * (maximum of 30 days leave per year * completed years of service - utilized days of leave)
   = ₹42000/30 * (30 * 15 – 140)

         = 1400 * (450 – 140)                                               = ₹4,34,000

Therefore,
Non-taxable Amount = The least of the above-calculated amounts
                                     = ₹300,000 will be exempted

Taxable Amount = Leave encashment received - The least of the above amount
                                    = ₹6,44,000 - ₹3,00,000       
                                    = ₹3,44,000