No tax blow for final leave encashment

Arup Batra, after having worked in the same company for over 15 years, was leaving his job for a better position in another firm. As he had served for a long time, his termination benefits were substantial.

One component was the leave salary to his credit.

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

I understand 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.

The article examines the veracity of this policy.

But first a little background.

. . .

What is leave salary?

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

The guidelines pertaining to lapsation, encashment and accumulation may be different from company to company. 

The accumulated leave may be availed during the service tenure or encashed at the time of retirement or leaving the job.

Encashment of the leave to one's credit is known as 'leave salary'.
Now, if any leave is encashed during the continuity of employment, it is chargeable to tax, irrespective whether the employee is in government or private service.

If encashed at the time of termination of service, the tax treatment differs.

For a government employee, the entire leave salary is tax-free.

For a private sector employee, it is partly exempted (Section 10(10AA) up to the least of the following:

• Cash equivalent of the leave salary in respect of the period of earned leave to the credit of employee at the time to retirement/superannuation (earned leave entitlements cannot exceed 30 days for every year of actual service), or
• 10 months' 'average salary', or
• Rs 300,000 (applicable from 1.4.98)
• 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". 'Otherwise' clearly suggests the exemption is available in the case of a person leaving his job for reasons other than retirement.

This treatment is also substantiated by a judgement, 142 CTR 325 CIT vs D P Malhotra, dated July 28, 1997.

The circumstances were the same as Batra's. That is, the assessee had resigned from his job and claimed exemption u/s 10(10AA) for the amount of leave salary.

The claim was rejected by the I-T officer, as he believed the benefit of Sec 10(10AA) was only available in cases where the amount was received by the assessee at the time of retirement, not resignation.

. . .

The CIT ruled in the taxpayer's favour.

The CIT held that 'retirement' was a word of wide import. In the context of employment, it means conclusion of a career.

However, one meaning of the word is 'resign', validated by a legal thesaurus.
Thus, both 'retirement' and 'resignation' result in the ending of relationship  with an employer.

Once an employee resigns, his service stands terminated from the date 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.

The word 'retirement' has not been used in the law in the restricted sense to mean 'retirement on superannuation'.

And, it is clear from the language of Section (10AA) itself that it has been used in the widest possible terms to mean and include all cases of retirement, whether on superannuation or otherwise.

What is relevant is the 'retirement'-- how it took place is immaterial for the purpose of this clause.

. . .

In other words, on acceptance of resignation, the employee stands retired from service.
The word 'retirement' has not been used in the law in the restricted sense to mean 'retirement on superannuation'.

And, it is clear from the language of Section (10AA) itself that it has been used in the widest possible terms to mean and include all cases of retirement, whether on superannuation or otherwise.

What is relevant is the 'retirement'-- how it took place is immaterial for the purpose of this clause.

. . .

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 would 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,the assessee had resigned from employment.

The 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."

The writer is Director, Wonderland Consultants