Leave encashment Allowability

The question of whether leave encashment paid out of a provision created in a previous financial year is allowable as a deduction under the Income Tax Act, 1961, hinges on Section 43B(f).

Legal Position

Under Section 43B(f) of the Income Tax Act, any sum payable by an employer in lieu of any leave at the credit of their employee is allowable as a deduction only in the previous year in which the sum is actually paid.

• Deduction on Payment Basis: Even if an employer creates a provision for leave encashment in their books of accounts in a previous year (based on actuarial valuation or otherwise), that provision is not an allowable deduction under Section 43B.

• The "Actual Payment" Rule: The tax deduction is deferred until the actual payment is made to the employee. If the payment is made in the current financial year (out of a provision created in a previous year), that payment becomes an allowable business expense in the year of such payment, provided it is made before the due date of filing the income tax return for that year.

Summary of Key Points

• Provision vs. Payment: Provisions for leave encashment are not tax-deductible expenses. They are considered "unascertained liabilities" for tax purposes.

• Allowability: The expense is allowed as a deduction in the financial year in which the encashment is actually paid to the employee.

• Compliance: To claim the deduction, the payment must be made on or before the due date for furnishing the return of income for the relevant previous year.

Summary: Leave encashment is not deductible when the provision is created. It is only allowable as a business deduction in the financial year in which the amount is actually paid to the employee, provided the payment is made before the due date for filing the income tax return for that year.