ITAT Surat ruling: Retired employee wins leave encashment tax dispute over ₹8.02 lakh exemption claim

A retired employee from Bharuch has won a legal battle against the Income Tax Department over the processing of his leave encashment tax exemption claim. The Income Tax Appellate Tribunal (ITAT), Surat Bench, on October 28, 2026, set aside a rectification order through which the department had added ₹5.02 lakh to his taxable income without providing him an opportunity to explain his position.

The ruling highlights the importance of following due process before the tax authorities modify an already processed income tax return (ITR), particularly when such changes increase an individual's tax liability or reduce a refund.

The case concerns Patel, a resident of Bharuch, who received ₹8.02 lakh as leave encashment upon retirement from a reputed company.

However, his employer's human resources department mentioned only ₹3 lakh as the tax-exempt portion of leave encashment in his salary certificate. Patel, meanwhile, claimed exemption on the entire ₹8.02 lakh under Section 10(10AA)(ii) of the Income Tax Act, 1961, while filing his ITR.

He also claimed a tax refund of approximately ₹1.53 lakh.

Initially, the Income Tax Department processed his return and issued a refund of ₹1.54 lakh, including ₹1,280 as interest for the delay in processing the refund.

However, the discrepancy between the exemption claimed in his ITR and the amount mentioned in his salary certificate subsequently attracted the department's attention.

On November 1, 2021, the Assistant Director of Income Tax (ADIT), Centralised Processing Centre (CPC), Bengaluru, passed a rectification order under Section 154 of the Income Tax Act.

Through this order, the department restricted Patel's leave encashment exemption to ₹3 lakh and added the remaining ₹5,02,333 to his taxable income.

The employee challenged the decision with the assistance of a Chartered Accountant, arguing that the department had modified his processed return without issuing a prior notice or providing him an opportunity to present his case.

The ITAT Surat Bench found fault with the procedure followed by the Income Tax Department.

Under Section 154(3) of the Income Tax Act, any rectification order that increases a taxpayer's liability or reduces a refund cannot be passed without giving the taxpayer prior notice and a reasonable opportunity of being heard.

Since the department had not followed this mandatory procedure before adding ₹5.02 lakh to Patel's taxable income, the tribunal set aside the rectification order.

Importantly, the tribunal's decision did not establish that the entire ₹8.02 lakh received by Patel was tax-exempt. It acknowledged that the applicable exemption ceiling for the relevant period was ₹3 lakh.

ITAT Surat said: “There were no reasons recorded under Section 154 notice and as held in decision of Hon’ble Supreme Court, the assessee should have been given the opportunity. As per CBDT Circular, revised limit for deduction under Section 10(10AA), Notification No.31/2023, the revised limit is ₹25 Lakh issued by the Ministry of Finance. Thus, without assigning the reasons, the AO cannot suo moto invoke Section 154 of the Act and pass the order without giving opportunity of hearing to the assessee. Therefore, the appeal of the assessee (Patel) is allowed.”

The tax treatment of leave encashment depends on whether the employee works for the government or a private-sector organisation.

• Government employees: Leave encashment received upon retirement is fully exempt under Section 10(10AA)(i).
• Non-government employees: The exemption is the lowest of the actual leave encashment received, 10 months' average salary, cash equivalent of unutilised earned leave (subject to a maximum of 30 days for each year of service), or the prescribed government limit.

The exemption ceiling for non-government employees retiring before April 1, 2023, was ₹3 lakh. It was subsequently increased to ₹25 lakh for eligible retirements on or after April 1, 2023.

Leave encashment received while an employee is still in service, however, remains fully taxable.

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