Introduction
The Union Budget for FY 2023-24 had a plethora of talking points from an individual taxpayer’s perspective as well as from the point of view of the economy as a whole. One of the key takeaways, from an employee-benefit standpoint, was the increase in the exemption limit for leave encashment from INR 3 lakhs to INR 25 lakhs.
Details about tax exemption of leave encashment
As per the tax provisions prevailing since 2002, leave encashment received on either retirement or resignation from a company was tax exempt in the hands of an employee up to a cumulative amount of INR 3 lakhs over the employee’s working lifetime. Bearing in mind inflation and increases in salaries since 2002, the government has now enhanced this limit to INR 25 lakhs. This can potentially lead to significant tax savings for employees with high leave balances and / or high salaries.
The advantages of this change from a salaried employee’s perspective will be evident through the illustration below. If we consider an individual who currently has a monthly basic salary of INR 3 lakhs, he / she would have a per-day encashment salary of INR 10,000 (assuming a 30-day month as per the leave policy). With an accumulated leave balance of 100 days, this employee will be eligible to an encashment amount of INR 1,000,000 on retirement / resignation.
| Exemption limit | INR 3 lakhs | INR 25 lakhs |
|---|---|---|
| Leave Encashment Amount | INR 1,000,000 | INR 1,000,000 |
| Tax Rate | 30% | 30% |
| Tax Payable | INR 210,000 | Nil |
| In-hand Encashment Amount | INR 790,000 | INR 1,000,000 |
The increase in the tax limit leads to an additional in-hand amount of INR 210,000 for the individual in this example.
While a monthly basic salary of INR 300,000 would currently only be applicable to top or middle management employees, it is important to bear in mind that employees can take advantage of this benefit when they retire or resign. Hence, these limits will come into play at some point in the future. Younger employees will experience increases in salary and / or accumulation of leave balances as time progresses. This will enable them to avail these tax benefits at the time of retirement / resignation. It is also worth noting that savings can be much higher for individuals who will be able to use a much larger chunk of the maximum exemption amount as against INR 1,000,000 as per our example.
Consequences
The underlying theme of the 2023 budget, concerning personal taxation, was the government’s push towards making the new tax regime more beneficial and attractive for taxpayers. They tried to achieve this by reducing tax rates across various bands. However, under this new regime, various tax exemptions are not available to an individual, which were available under the old scheme. Tax exemptions on leave encashment is still one of the few avenues that a salaried taxpayer can utilize. Experience suggests that tax implications or changes in leave policy have an effect on employees’ decision-making. Accordingly, we would expect this update to have the following impacts:
- Voluntary leave encashment whilst in service is likely to reduce. This is because leave encashment whilst in service is not tax exempt unlike leave encashment on retirement / resignation.
- Tax exemptions are not a major driver of how employees utilize their leaves. However, employees will be cognizant of the fact that they can receive a larger payout on retirement / resignation and will accordingly try to maximize their leave balances to the extent possible. This is likely to reduce leave utilization to some extent. Such a behavioral change will be more evident amongst the following groups of employees since they will have the most to gain by encashing their leaves balances at the time of leaving the company:
- high-salaried employees with large leave balances
- employees who are close to retirement or are looking to resign
- The market trend over the past few years has typically been of companies disallowing carry-forward or encashment of leave balances. Alternatively, where carry-forward of leaves is allowed, companies have tried to gradually reduce the maximum accumulation limits. These changes were brought about in order to promote utilization of leaves and a healthy work-life balance, while also reducing the company’s balance sheet liabilities at the same time. However, in order to offer an avenue for employees to receive tax-exempt income, companies might consider altering their leave policies by way of increasing the maximum accumulation limit or re-introducing carry-forward and / or encashment of leave balances. While this will be financially beneficial to employees, employees might now utilize fewer leaves, which might not be aligned with the company’s objectives mentioned above. The impact on the Balance Sheet and Profit & Loss Account of the company should also be considered before making such a change.
Conclusion
The increase in the tax exemption limit on leave encashment is bound to have ripple effects on the decision making for both, employees and employers, when it comes to their leave balances and the leave policy respectively. The change in the availment / encashment experience of employees will emerge over the next 2-3 years as they alter their behavior in light of the increased exemption limit. We would expect companies to experience lower utilization and encashment in service while accumulation for encashment on resignation / retirement would be expected to increase going forward.
Employers on the other hand will have an immediate decision on their hands based on their objectives and priorities. There will be differing viewpoints due to the conflict between HR objectives and the financial impact of such a change. This decision will also depend on the general outlook within the workforce and the extent to which employees push for such changes in the leave policy. Lastly, modifications made to peer companies’ leave policies are also likely to influence the final decision.
We can help companies evaluate their leave policies and the financial impacts of any proposed changes on their books. Also, if you wish to discuss about the exemption limit or market trends pertaining to leave policies, feel free to get in touch with us at actuaries@thanawalaconsultancy.com or harshit@thanawalaconsultancy.com.