Section 10(10AA)- Tax Exemption for Leave Encashment

Section 10(10AA) of the Income Tax Act, 1961 provides important tax exemptions for leave encashment (also called leave salary) received by employees. This provision has undergone significant changes in recent years, most notably with the increase in exemption limits in Budget 2023. Let me explain this section in detail with practical examples to help you understand how it works.

What is Leave Encashment?

Leave encashment refers to the monetary compensation employees receive for their unused paid leaves. When employees don’t utilize all their entitled leaves, many employers allow them to either:

1. Carry forward the unused leaves to next year
2. Get paid for those unused leaves (called leave encashment)

This payment can happen:

• During employment (periodic encashment)
• At the time of retirement/resignation
• To legal heirs in case of employee’s death

Key Features of Section 10(10AA)

1. Tax Treatment Varies by Timing and Employer Type

The taxability of leave encashment depends on two main factors:

• When it’s received(during service or at retirement/resignation)
• Type of employer(government or non-government)

2. For Government Employees

• Leave encashment received at retirement/resignationis fully tax-exempt
• Leave encashment received during serviceis fully taxable as salary income
• Legal heirs receiving leave encashment after employee’s death get full exemption

3. For Non-Government Employees

• Leave encashment received during serviceis fully taxable as salary income (but tax relief available under Section 89)
• Leave encashment received at retirement/resignationis partially exempt based on a specific calculation
• Legal heirs receiving leave encashment after employee’s death get full exemption

Budget 2023 Update: Increased Exemption Limit

A major change was introduced in Budget 2023:

• The exemption limit for non-government employees was increased from ₹3 lakh to ₹25 lakh
• This is a lifetime limit– any exemptions claimed in previous years reduce this ₹25 lakh ceiling

Calculation of Exemption for Non-Government Employees

For non-government employees, the exempt amount is the least of the following four values:

1. ₹25,00,000(the government-notified limit)
2. Actual leave encashment received
3. 10 months’ average salary(average of last 10 months’ salary before retirement)
4. Cash equivalent of unutilized leave(calculated as Salary per day × Unutilized leave days, with maximum 30 days per year of service)

Salary includes: Basic + Dearness Allowance (if part of retirement benefits) + Commission (if fixed percentage of turnover) 

Practical Example 1: Retirement Scenario

Let’s consider Mr. Sharma, a private sector employee retiring after 20 years of service:

• Basic + DA at retirement:₹60,000 per month
• Leave entitlement:30 days per year
• Total leave earned:30 × 20 = 600 days
• Leaves utilized:200 days
• Unutilized leaves:400 days
• Leave encashment received:₹8,00,000
• Average salary of last 10 months:₹60,000 (no change)

Calculation:

1. Government limit: ₹25,00,000
2. Actual received: ₹8,00,000
3. 10 months’ average salary: ₹60,000 × 10 = ₹6,00,000
4. Cash equivalent of unutilized leave:

• Salary per day = ₹60,000/30 = ₹2,000
• Maximum allowable leaves = 30 days/year × 20 years = 600 days
• Leaves already taken = 200 days
• Leaves considered = 600 – 200 = 400 days
• But maximum is 30 days/year × 20 years = 600 days
• So ₹2,000 × (600 – 200) = ₹8,00,000

Exempt amount: Least of above = ₹6,00,000 (10 months’ salary)
Taxable amount: ₹8,00,000 – ₹6,00,000 = ₹2,00,000

Practical Example 2: Resignation Scenario

Ms. Patel resigns after 15 years in a private company:

• Basic + DA:₹45,000 per month
• Leave entitlement:25 days/year
• Total leave earned:25 × 15 = 375 days
• Leaves utilized:150 days
• Unutilized leaves:225 days
• Leave encashment received:₹5,00,000
• Average last 10 months salary:₹45,000

Calculation:

1. Government limit: ₹25,00,000
2. Actual received: ₹5,00,000
3. 10 months’ salary: ₹45,000 × 10 = ₹4,50,000
4. Cash equivalent:

• Salary per day = ₹45,000/30 = ₹1,500
• Maximum allowable = 30 × 15 = 450 days
• Leaves taken = 150 days
• Leaves considered = 450 – 150 = 300 days
• ₹1,500 × 300 = ₹4,50,000

Exempt amount: Least of above = ₹4,50,000
Taxable amount: ₹5,00,000 – ₹4,50,000 = ₹50,000

Important Notes

1. Lifetime Limit:The ₹25 lakh exemption is cumulative across all employers during your career. If you claimed ₹5 lakh exemption earlier, only ₹20 lakh remains
2. Multiple Employers in Same Year:If receiving leave encashment from multiple employers in same financial year, total exemption cannot exceed ₹25 lakh
3. Calculation Method:Even if your employer allows more than 30 days/year, tax calculation considers maximum 30 days/year
4. Form 10E:To claim relief under Section 89 for leave encashment during service, you must file Form 10E
5. New Tax Regime:The exemption under Section 10(10AA) is available under both old and new tax regimes

Special Cases

1. Legal Heirs:Leave encashment received by legal heirs after employee’s death is fully exempt for both government and private employees
2. Early Career Resignation:If you resign with few years of service, your exemption may be quite low as it’s based on 30 days/year of completed service.