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Recently, one of my friends left his job with a company after over 15 years of service. He had not retired, neither had he accepted any VRS. He had simply resigned as he had been offered a better position in another firm.

Now, since he had served the company for a long time, his termination benefits were quite substantial. One of the components of such 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 given to understand that this is the general practice as the exemption is taken to be available only to 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 may be availed of by the employee during his service tenure or such leave 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’.

Now, if any leave is encashed during the continuity of employment, it is chargeable to tax, irrespective of whether the employee is in government or private service.

On the other hand, any leave encashment at the time of termination of service tax treatment differs. While for a government employee the entire amount of leave salary is tax-free, for a private sector employee, leave salary is partly exempted (u/s 10(10AA)) up to the least of the following:

Cash equivalent of the leave salary in respect of the period of earned leave standing to the credit of the 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 3 lakh (applicable from April 1, 1998); or

the amount of leave encashment actually received at the time of retirement.

The argument

Sec. 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 were exactly similar to those 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 Sec. 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 taxpayer’s favour. It held that ‘retirement’ is a word of wide import. In the context of employment, it means conclusion of a career. However, one of the meanings of the word ‘retire’ is ‘to resign’. This is validated by a legal thesaurus, where ‘resign’ is one of the meanings of ‘retirement’.

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 stands 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.

The word ‘retirement’ has not been used in the law in the restricted sense to mean ‘retirement on superannuation’. On the other hand, it is clear from the language of Sec. (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 ‘retirement’ — how it took place is immaterial for the purpose of this clause.

It is clear, therefore, that if on retirement, even on resignation by the employee, an employee gets by way of leave encashment any amount, Sec. 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, the assessee had resigned and retired from employment. The HC 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 s. 10(10AA) would apply.”

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