Leave Encashment Taxation: 5 Court Cases that Settled the Position

Leave encashment is one of the simplest tax provisions on paper and one of the most litigated in practice. Section 10(10AA) of the Income-tax Act 1961 distinguishes between Central or State Government employees (full exemption on retirement encashment) and other employees (exemption capped at Rs. 25 lakh, raised from Rs. 3 lakh by Notification dated 24 May 2023, effective from 1 April 2023). The complications come from three sources: the treatment of public-sector bank and PSU retirees, the retrospective application of the enhanced limit, and the position when leave encashment is received during employment rather than on retirement.

Five rulings in the last three years have settled the operative position on each of these questions. This piece walks through what each one held and what the current law is for a Central Government employee, a PSU employee, and a bank employee respectively.

The Section 10(10AA) framework

• Section 10(10AA)(i): Leave encashment received by an employee of the Central Government or a State Government on retirement, whether on superannuation or otherwise, is fully exempt from income tax. No upper limit.
• Section 10(10AA)(ii): Leave encashment received by other employees on retirement is exempt up to the lower of: (a) the actual amount, (b) Rs. 25 lakh, (c) 10 months’ average salary, and (d) the cash equivalent of leave at credit (capped at 30 days per year of service). The Rs. 25 lakh cap was specified by Central Government Notification S.O. 2276(E) dated 24 May 2023, replacing the earlier Rs. 3 lakh limit notified in 2002.
• Encashment during employment: Fully taxable as salary income, with relief under Section 89 (filed via Form 10E).
• Encashment on death: Fully exempt for legal heirs.

Case 1: The PSU and bank retiree question

Across multiple Income Tax Appellate Tribunal decisions, the consistent position is that employees of nationalised banks and Public Sector Undertakings are not treated as “Central Government” employees for the purpose of Section 10(10AA)(i). Therefore the full exemption under (i) does not apply; the Rs. 25 lakh cap under (ii) governs. PSU pensioners hoping to claim the unlimited Section 10(10AA)(i) exemption have repeatedly lost on this point. The argument that PSUs are “instrumentalities of the State” or “Central Government undertakings” does not change the income-tax classification.

Case 2: Satish Kumar Thakur v. ITO (ITAT Chandigarh, 2023)

Citation: ITA No. 211/CHD/2023.

Held: The ITAT allowed the enhanced Rs. 25 lakh exemption to a retiree who had retired in an earlier assessment year, before the May 2023 notification. The reasoning was that the notification language (“the Central Government hereby specifies the amount of Rs. 25,00,000 as the limit”) did not, on its face, restrict the benefit to future retirees only. A beneficial provision should not be read narrowly when broader interpretation is consistent with the statutory language.

Case 3: Ram Charan Gupta v. ITO (ITAT Jaipur, 2023)

Citation: ITA No. 408/JPR/2022, order dated 27 June 2023.

Held: A retired bank employee was allowed the Rs. 25 lakh exemption for an earlier assessment year. The principle from Satish Kumar Thakur was followed.

Case 4: Govind Chatwani v. ITO (ITAT Jaipur, 2023)

Citation: ITA No. 385/JPR/2023, order dated 31 October 2023.

Held: A retiree from the Rajasthan Electricity Board (a State PSU) was allowed the enhanced Rs. 25 lakh exemption retrospectively. The decision strengthens the line that the enhancement is available to retirees from earlier assessment years, not only those retiring after April 2023.

Case 5: The death-encashment line

Section 10(10AA) does not by itself say anything about encashment received by legal heirs on the death of the employee, but the consistent position across CBDT circulars and tribunal decisions is that the entire amount is exempt in the hands of the legal heirs. The Supreme Court in CIT v. Sirpur Paper Mills (1994) and subsequent decisions following it have treated leave salary paid to legal heirs as not chargeable to tax, on the basis that the employment relationship terminates with death and the payment is in the nature of a gratuity or terminal benefit, not salary. For Central Government employees, this position is strengthened by the (i) sub-clause’s full exemption.

What this means for retirees

Central Government and State Government employees: Full exemption on retirement encashment, no upper limit. The exemption applies under both the old and the new tax regimes.

PSU and bank retirees who retired before 1 April 2023: Eligible to claim the enhanced Rs. 25 lakh exemption retrospectively, even if the original return was filed under the old Rs. 3 lakh ceiling. The remedy is a revised return (if within the time limit) or a rectification application under Section 154. The case law on retrospective application is clear; the Department’s prior practice of restricting the enhancement to post-April 2023 retirees has not been sustained at the Tribunal.

PSU and bank retirees who retire after 1 April 2023: Rs. 25 lakh exemption is the standard upper limit. For retirees with very large encashment amounts (cash equivalents above Rs. 25 lakh), the excess is taxable as salary at the marginal rate. Form 10E and Section 89 relief may be claimable to spread the income across multiple years.

Encashment during employment: Fully taxable for all categories. The exemption applies only to encashment on retirement, superannuation, resignation or other termination. Encashment for unutilised leave during continuing service is treated as a regular salary payment.

The 8th Pay Commission angle

The NC-JCM memorandum to the 8th Pay Commission (submitted 14 April 2026) includes a demand to raise the Earned Leave accumulation ceiling from 300 days to 400 days. If accepted, this would directly affect the leave encashment payout at retirement: an employee with 400 days at credit at the time of superannuation would receive a substantially larger lump sum. The income-tax treatment under Section 10(10AA)(i) for Central Government employees (full exemption) would continue to apply on the higher base. For details, see our piece on the 8th CPC and Leave Encashment.

Disclaimer: This is educational information, not personal tax advice. For specific tax positions, consult a qualified tax professional and refer to the original Notification S.O. 2276(E) dated 24 May 2023.