Saving tax on leave encashment amount – Section 89(1)

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When you get leave salary (that is, when you encash your leaves) – either while in service or when you resign or retire, the amount is taxable in many cases.

Is there a way to save the income tax on this? Yes! Read on.

When you encash your leaves – either while in service or when you resign or retire, the amount is taxable in many cases. (Please read “Leave encashment / leave salary – Is it taxable?” to know the taxation rules regarding leave salary / encashed leaves).

What are the implications?

Since the leave salary is taxable in certain cases, it can have serious implications on your tax liability.

For example, if you encash last 5 years’ accumulated leave this year, the entire amount would become taxable in this year (although the amount actually belongs to 5 years, and not just this year), greatly increasing your income tax liability!

Similarly, if you are retiring / resigning from a private firm this year, and the actual leave encashment amount you receive is a lot higher than the exemption allowed (say, you receive Rs. 5 Lakhs as leave encashment), the entire excess amount would become taxable this year – although the amount would actually belong to many years, and not just this year.

The entire amount would likely fall in the highest tax bracket for this year. If this amount could be distributed among the years it actually belongs to, your tax liability might actually be lower!

Can this be done?

Income Tax Relief Available as per Section 89(1)

Yes, you can get some relief in such cases. However, you would need to do a lot of calculations (including revisiting previous years’ income tax calculations!) to claim this relief.

Here is the process (with a running example):

1. Find out the years to which the encashed leave belongs

(Say it belongs to FY 2005-6, 2006-7 and 2007-8)

2. Add a portion of the amount received on leave encashment to the taxable income of those earlier years – in proportion to which the leave belongs to each year.

(Say you add Rs. 25,000, Rs. 27,500 and Rs. 27,500 to each of these years respectively)

3. Calculate the additional tax liability for each of these years as if this portion of the leave encashment amount would be taxed in that year

(Say additional tax liability is Rs. 5,000, Rs. 5,500 and Rs. 5,500 in each of these years respectively. The total is Rs. 16,000)

4. Calculate current year’s income, and calculate the tax on it. It has to be calculated in two ways:

(a) After including the full leave encashment amount in your income

(Say it is Rs. 95,000)

(b) After including only the leave encashment amount for this year in your income (that is, after excluding the leave encashment amounts belonging to earlier years)

(Say it is Rs. 77,000)

5. Find out how much extra you would be paying if the entire leave encashment amount is taxed in this year.

Thus, find out 4(a) – 4(b).

(It is Rs. 95,000 – Rs. 77,000 = Rs. 18,000 in our example).

6. Compare the amount calculated in step 5 (4(a) – 4(b)) with the amount calculated in step 3 (the sum of additional tax liability in each year to which the leave belongs).

That is, find out 5 – 3.

(In our example, it is Rs. 18,000 – Rs. 16,000 = Rs. 2,000)

7. If the amount in step 6 is positive, that is the amount of tax relief that you can claim. If the amount is negative, no relief is available to you.

(In our example, the tax relief that can be claimed is Rs. 2,000)

You would need to specifically ask your assessing office (AO) for this relief by filling out and submitting Form 10-E.

Download Form 10E

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