When Mr Patel from Bharuch, Gujarat, retired from a well-respected company, he received Rs 8.02 lakh as leave encashment. However, for reasons unknown, his company's HR department recorded only Rs 3 lakh as the income tax exempted amount for leave encashment in the salary certificate. Nonetheless, Patel filed his income tax return (ITR) claiming a tax refund of Rs 1.53 lakh and sought full income tax exemption on his Rs 8.02 lakh leave encashment under Section 10(10AA)(ii) of the Income Tax Act, 1961.
This created problems as Patel's salary certificate mentioned that his income tax exemption on leave encashment is restricted to Rs 3 lakh while Patel had claimed full Rs 8.02 lakh income tax exemption in his ITR.
Initially this issue was overlooked by the Income Tax Department and his ITR was successfully processed with Rs 1.54 lakh tax refund including Rs 1,280 interest for delay in tax refund. But later on the ADIT, CPC Bengaluru noticed this discrepancy between Patel's claim and his company's salary certificate and so on November 1, 2021, took action against it. On that date, the ADIT, CPC Bengaluru, passed a rectification order and restricted Patel's tax exemption for leave encashment claim to Rs 3 lakh and added Rs 5.02 lakh to his income and made it taxable. Patel was very unhappy on receiving this order, and did not want to go down without a fight. So he took CA Bhupendra Mehta's help and filed a case.
On October 28, 2026, Patel won the case in the Income Tax Appellate Tribunal (ITAT) Surat.
Chartered Accountant Varun Singhal said to ET Wealth Online that Patel won the case in ITAT Surat on procedural grounds and not on the merits. The Income Tax Department's processing centre first accepted his revised income tax return (ITR) and gave him an income tax refund. However, later on the Income Tax Department passed a rectification order under Section 154 and added Rs 5,02,333 back to his income, without any notice or hearing.
The ITAT Surat Bench held that this was not allowed as under Section 154(3) if an order is issued that increases income or reduces an income tax refund requires prior notice and a reasonable opportunity of being heard. Thus ITAT Surat set aside the rectification order, however, the tax tribunal did not rule that the full Rs 8,02,333 of leave encashment was tax-exempt. It acknowledged that the exemption limit for that year was Rs 3 lakh.
Singhal explains how much leave encashment is exempt from income tax:
Government employees: Leave encashment at retirement is fully exempt under section 10(10AA)(i).
Non-government employees: The exemption is the lowest of four amounts: the actual amount received, 10 months' average salary, the cash value of unused leave (maximum 30 days per year of service), or the notified limit.
The income tax exemption limit for leave encashment was Rs 3 lakh if your retirement date was before April 1, 2023. After this date, the limit was increased to Rs 25 lakh for non-government employees. However, leave encashment received during service is taxable.
CA Bhupendra Mehta representing Patel argued before ITAT Surat that the ADIT, CPC Bengaluru, had modified the original order under Section 143(1) when there was no mistake and rectified it under Section 154 suo moto when the same power was not with the AO.
CA Bhupendra Mehta also argued that initially, the Income Tax Assessing Officer (AO) had rightly allowed Patel's leave encashment claim. However, later Patel's claim was rejected and a rectification order was passed which itself did not have any reasons recorded prior to being passed.
Mehta also relied upon the decision of the Hon'ble Supreme Court in the case of M. Chockalingam & Another vs. CIT, 1963 AIR 1456, where the Supreme Court had held that if there are no reasons recorded for invoking Section 154, the order passed under Section 154 does not survive.
Ms Suchitra Kamble, judicial member and Mr B.M Biyani, accountant member of ITAT Surat, heard the arguments and observed that as per CBDT Circular dated May 31, 2002 gazette notification, the leave encashment claim was restricted to Rs 3 lakh, but, while invoking Section 154, Patel was not given an opportunity (to explain it).
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 Rs 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."
