Leave encashment in India - a definitive guide
A study conducted by Gallup revealed that a massive 61% of people look for better work-life balance and personal well-being when searching for a new job. Leave is one of the important criteria that allows employees to achieve a strong work-life balance. Getting complete time-off from work helps employees recover from any stress and prevents burnout. Understanding this, companies around the globe have started providing ample leave to their employees. Paid leave, casual leave, sick leave, and maternity leave are the common leave types that you can offer your employees.
Some employees enjoy this time-off, while others save up their leave and risk letting it go unused. If you're an HR or payroll professional, you likely receive many questions around unused leave and need to know everything about the topic. We've put together this article to help you understand the types of leave and the concept of leave encashment, including its calculation and taxation rules.
Types of leave
All salaried individuals are entitled to a certain amount of leave according to Indian labour laws. Let's take a look at the types of leave that you can offer to your employees.
Employees earn paid leave, earned leave, or privilege leave after a specific number of working days. The condition to avail and the number of leave applicable vary from one company to another. This leave is calculated on a pro-rata basis. Employees who are eligible for paid leave receive anywhere from 12 to 20 days of earned leave per year.
This type of leave is used for personal reasons, such as festival holidays and vacations. Usually employees pre-plan and combine their paid leave to take long breaks.
There will be cases where the employee do not exhaust all their paid leave. In such a scenario, organizations can allow their employees to either carryover or encash their unused paid leave. Companies that allow encashment of unused leave can credit the equivalent amount at the beginning of the subsequent calendar year or at the time of the employee's resignation or retirement from service.
Casual leave is offered to accommodate any unforeseen circumstances. Companies provide their workers with seven to 12 casual leave requests per year. They allow their employees to take a minimum of half a day of leave to a maximum of three days of casual leave per month. In most organizations, anything beyond three days can be availed only using the employee's paid leave balance.
Generally, companies do not allow to carry forward or encash unused casual leave.
Employees can avail sick leave or medical leave if they fall ill and cannot work. If the worker takes more than three days of sick leave at a time, they will be required to produce a medical certificate. This type of leave is mandated by law, and companies offer up to 14 days of sick leave per year. Most organizations do not allow encashment or carrying forward of unused sick leave to the next year.
As per the Maternity Benefit Act of 1961, all employees pregnant with their first two children are eligible for maternity leave of up to 26 weeks. Out of the 26 weeks, up to 8 weeks can be claimed before delivery. For women who already have two children, the maternity leave for the third child is limited to 12 weeks. During this time, employees must be paid their full wages, equivalent to their last drawn pay. The act also extends leave benefits in case of a miscarriage, surrogacy, or adoption. This type of leave is not considered for encashment.
Now that we have understood the common types of leave, let's learn about how to calculate leave encashment.
What is leave encashment?
Leave encashment refers to the amount received by an employee in exchange for unused paid leave provided by the organization.
Although leave is mandatory, leave encashment is not mandated by Indian labour laws. The employer decides whether the unused paid leave can be encashed or carried forward to the next year. A study suggests that nearly 10% of paid leave goes unused per year. Encashment of such leave will be beneficial for your employees, and in turn make your organization a better place to work.
Leave encashment policy varies from company to company. Business owners and payroll professionals can determine when they can provide the encashed amount to their employees. If the employee is still working at the company, encashment of unused leave from the previous year can be credited during the first pay cycle of the following year. If the employee has retired or resigned from their position, the encashed amount can be credited along with the full and final settlement.
This brings us to the next question: As an employer, should you be deducting any tax on the encashed amount, or is it exempt from taxation? Continue reading this article to find out the answers.
Is it taxable?
An employee's encashed leave is taxable depending on when they receive it.
Leave encashment while at the company: The encashed amount is fully taxable, as it is considered a part of salary income by the Income Tax Department. This applies to both government and private employees. However, individuals can claim tax relaxation under Section 89 of the Income Tax Act.
Leave encashment upon death: When a legal heir receives the encashment on behalf of the deceased employee, the amount is fully exempt from tax.
Leave encashment at the time of retirement or resignation: Encashment received by the Central and state government employees at the time of retirement is fully exempt from tax. In the case of non-government employees, the encashed amount is partially exempt based on the computation provided under Section 10 (10AA)(ii); the balance amount, if any, is taxable as salary income.
Let's understand how to calculate the encashment amount before we learn about the Section 10 clause.
Leave encashment calculation
Assume that Mr. Praveen retired after 20 years of service. At the time of his retirement, his monthly basic pay and dearness allowance was Rs. 60,000. The private company that Praveen worked for allowed him to take 20 days of paid leave per year. Out of the 400 total paid leave days, he used only 200 and is left with another 200 days of unused leave at the time of his retirement.
Leave encashment amount is calculated based on the below formula.
Encashed amount = Basic salary per day X Number of unused earned leaves
In Praveen's case the encashed amount would be:
Encashed amount = (60,000 / 30) X 200 = 2,000 X 200 = Rs. 4,00,000
The leave encashment amount that Praveen would receive is Rs. 4 Lakhs.
Since Praveen is a non-government employee, his encashment amount is only partially exempt from tax based on the computations under Section 10(10AA)(ii).
Now we have to calculate the exemptions allowed on his encashed amount.
Tax exemptions on leave encashment
The encashed amount is exempt from tax up to the least of the following:
The actual amount received from the organization
Average salary over the last 10 months
Cash equivalent of unused earned leave
Maximum limit fixed by the government, which is Rs. 3 Lakhs
Consider that Praveen had received a sum of Rs. 4 Lakhs as an actual amount from the organization at the time of his exit. His average salary over the last 10 months can be calculated using his basic pay and dearness allowance, which is Rs. 60,000 X 10 = Rs. 6 Lakhs.
The cash equivalent of unused leaves is calculated by multiplying salary per day with the unutilised leave for every year of service. The maximum cap of leave is set as 30 days per year. In Praveen's case, the cash equivalent of unused leave will be:
(60,000/30) X ((30 X 20) - 200) = Rs. 8 Lakhs.
The tax exemption on Praveen's encashed amount will be the minimum of any one of the below values:
|Actual amount received from the organization
|Rs. 4 Lakhs
|Average salary of last 10 months
|Rs. 6 Lakhs
|Cash equivalent of unused earned leave
|Rs. 8 Lakhs
|Maximum limit fixed by the government
|Rs. 3 Lakhs
From the above table, the amount of encashed leave exempted under Section 10(10AA)(ii) is Rs. 3 Lakhs, the least among the four.
The taxable amount is calculated by subtracting the lower value from the lump sum given by the organization. In Praveen's case, the taxable leave encashment is:
|Leave encashment received
|Rs. 4 Lakhs
|Less value among the four particulars under Section 10(10AA)(ii)
|Rs. 3 Lakhs
|Total taxable leave encashment amount
|Rs. 1 Lakh
Rs. 1 Lakh from Praveen's encashment amount will be added to his salary income section and will be taxed according to the slab he falls under.
As an employer, you're required by law to provide a certain amount of leave to your employees. In addition to maintaining compliance, offering ample leave reflects positively on your company's work culture and increases your employee recruitment rate.
Employees after completing a specific period of service will be eligible for paid leave. Generally, the employer decides whether the unused paid leave can be encashed or carried forward to the following year.
According to the organization's leave policy, the encashment process can be carried out during various time periods.
The encashment amount received by the employee while in service is fully taxable for both government and non-government workers.
The amount received by legal heirs on behalf of a deceased employee is fully exempt from tax.
The amount received at the time of retirement or resignation is partially taxable only for non-government employees. Allowed tax exemption on the encashed amount is the least of any of the following values:
Actual amount received from the organisation
Average salary of the last 10 months
Cash equivalent of unused leaves
Maximum limit fixed by the government (Rs. 3 Lakhs)
The balance encashed amount is taxable as salary income.
Although the calculation and taxation of leave encashment can appear complicated, you can simplify the process with the help of powerful payroll software. Zoho Payroll comes integrated with an intuitive HRMS tool that keeps tabs on employee leave balances.
Next up, learn how to choose the right payroll software that takes care of tedious calculations in our article and focus on growing your business.
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