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'Leave salary' - Let the taxman decide

A N Shanbhag | August 28, 2004 12:43 IST

Recently, a friend of mine left his company after working there for 15 years. He didn't retire or take voluntary retirement. He had simply resigned as he had been offered a better job in another firm.

As he had been serving for a long time, his termination benefits were quite substantial. One of the components of these proceeds was the leave salary standing to his credit.

The problem arose when the company wanted to deduct tax on the full amount of such leave salary in spite of there being a specific section in the Income Tax Act which provides exemption thereon up to specified limits.

I am also given to understand that this is the general practice as the exemption is taken to be available only for those employees who are retiring and not to those who resign. This article examines the veracity of this policy. But first a little background.

What is leave salary?

If  leave standing to the employee's credit is not taken within a year, as per the service rules it may lapse or it may be encashed or it may be accumulated.

The accumulated leave standing to the credit of an employee may be availed by the employee during his service time or, subject to service rules, such leaves may be encashed at the time of retirement or leaving the job. Encashment of leave by surrendering leave standing to one's credit is known as 'leave salary'.

Broad tax treatment of leave salary

If leave encashment is received during the continuity of employment, it is chargeable to tax, irrespective of the fact whether the employee is in government service or private service. The employee can, however, claim relief in terms of Section 89.

Leave encashment at the time of retirement on superannuation or otherwise -- even such leave encashment is taxable, however, subject to the exemptions provided by Section 10(10AA) as follows:

Leave salary at the time of retirement to central/state government employees -

In the case of central/state government employee, any amount received as cash equivalent of leave salary in respect period of earned leave at his credit at the time of retirement/superannuation, is exempt from tax [Section 10(10AA)(i)].

Leave salary at the time of retirement to other employees -

In the case of a non-government employee, leave salary is exempt from tax to the extent of the least of the following:

  • Cash equivalent of the leave salary in respect of the period of earned leave standing to the credit of employee at the time to retirement/superannuation (earned leave entitlements cannot exceed 30 days for every year of actual service rendered for the employer from whose service he has retired); or
  • 10 months' 'average salary'; or
  • Rs 300,000 (applicable from April 1, 1998)
  • the amount of leave encashment actually received at the time of retirement.

The argument

Section 10(10AA) clearly uses the words, "on retirement or otherwise". The key seems to be the word 'otherwise' which clearly seems to suggest that the exemption under the section is available in the case of a person leaving his job for reasons other than retirement.

This treatment is also further substantiated by a judgement 142 CTR 325  CIT vs D P Malhotra dated July 28, 1997. The circumstances of this case where exactly similar to those which my friend found himself in viz. the assessee had resigned from his job and had claimed exemption u/s 10(10AA) for the amount of leave salary.

The claim of the assessee was rejected by the ITO as he was of the opinion that the benefit of Section 10(10AA) is available only in cases where the amount is received by the assessee at the time of retirement which, according to him, did not include resignation.

The CIT ruled in the assessee's favour. Prior to the incorporation of Section 10(10AA), any amount received by an employee on retirement from service by way of cash equivalent of unutilised earned leave was chargeable to income-tax under the head "salaries".

With a view to avoiding hardships to retiring employees, this clause was inserted with effect from April 1, 1978. It was amended by the Taxation Law(Amendment) Act, 1984.

By the said amendment, the words "on superannuation" occurring in clause (10AA) were substituted by the words "whether on superannuation". This amendment was made with retrospective effect from the date of inception of cl. (10AA) -- April 1, 1978.

So the question that arose was whether termination of employment by resignation amounts to "retirement" within the meaning of this clause or not. If it amounts to "retirement", the case of an employee who has resigned from service would fall under this clause, otherwise not.

The CIT held that "retirement" is a word of wide import. In the context of employment, it means conclusion of a career. One of the meanings of the word "retire" is "resign".

Thus both "retirement" and" resignation" result in the conclusion of the service career from that particular employer i.e. resignation from service is also one of the modes of retirement from service.

Once an employee resigns, his service stand terminated from the date on which his letter of resignation is accepted by the appropriate authority, unless there is any law or statutory rule governing the conditions of service to the contrary. In other words, on acceptance of resignation, the employee stands retired from service.

It is, therefore, clear that if on retirement, even on resignation by the employee, an employee gets by way of leave encashment any amount, Section 10(10AA) would apply and the assessee will be entitled to the benefit of the said clause to the extent mentioned therein.

The same view is supported by the decision of the Madras high court in CIT vs. R J Shahney (1986) 54 CTR (Mad) 360. In that case also the assessee had resigned and retired from employment.

The Madras high court had held: "The retirement may be of various kinds. It may be on superannuation or voluntary. If there is any voluntary retirement from service, we are satisfied that the provisions of Section 10(10AA) would apply."

To sum

I submit that it would be beneficial for everyone if laws are followed more in spirit than in word. Though in this case, the words also point in the same direction as the spirit. Section 10(10AA) has been introduced specifically to bestow some relief to assessees. It is not as if the entire amount of leave salary would be exempted in every case.

As mentioned above, there have been put into place certain limits and if the assessee is indeed satisfying the conditions mentioned, merely interpreting the law against the assessee amounts only to harassment.

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