Is LPR encashment taxable at retirement?

What does the law say?

Two provisions of the Income Tax Ordinance, 2001 decide the answer.

Section 12(2)(a) defines salary to include “any pay, wages or other remuneration provided to an employee, including leave pay, payment in lieu of leave”. Cash paid for leave not taken is therefore salary unless something exempts it.

Clause (19) of Part I of the Second Schedule is that exemption, and it is narrow. It covers:

“Any sum representing encashment of leave preparatory to retirement of a member of the Armed Forces of Pakistan or an employee of the Federal Government or a Provincial Government.”

Section 53 gives effect to Second Schedule exemptions, “subject to any conditions and to the extent specified therein”. Clause (19) sets no rupee cap, so where it applies, the whole encashment sum is exempt.

Who retires	LPR or leave encashment
Member of the Armed Forces of Pakistan	Exempt under clause (19)
Employee of the Federal Government	Exempt under clause (19)
Employee of a Provincial Government	Exempt under clause (19)
Anyone else (private company, bank, NGO, and any employer the clause does not name)	Salary under section 12(2)(a)

How does it work in practice?

Government and Armed Forces. The encashment is left out of taxable salary. The clause is tied to leave “preparatory to retirement”, so its text does not reach leave encashed during service for some other reason.

Everyone else. The amount is added to salary for the tax year in which it is received. Section 12(5)(b) treats amounts paid by “a past employer” as received from employment, so encashment paid a few months after you leave is still salary. Where salary is more than seventy-five per cent of taxable income, the rates in clause (2) of Division I of Part I of the First Schedule apply.

Statutory bodies and corporations. The Second Schedule shows that the drafters named such bodies when they meant to. Clause (13)(i), on gratuity and commutation, refers to “an employee of the Government, a Local Government, a statutory body or corporation”. Clause (19) does not. The Ordinance does not say whether an employee of a government-owned corporation counts as an “employee of the Federal Government” for clause (19), and this page does not settle that point.

Worked example (illustrative figures)

Two people retire in tax year 2027 (1 July 2026 to 30 June 2027). Each earned Rs. 2,000,000 of salary in that year before retiring, has no other income, and receives Rs. 600,000 for unused leave.

Asif, an assistant in a Punjab Government department in Lahore

1. The Rs. 600,000 is encashment of leave preparatory to retirement of a Provincial Government employee, exempt under clause (19).
2. Taxable salary stays Rs. 2,000,000.
3. Clause (2), slab above Rs. 1,200,000 up to Rs. 2,200,000: Rs. 6,000 plus 11% of Rs. 800,000 = Rs. 6,000 + Rs. 88,000 = Rs. 94,000.

Bushra, a branch officer at a private bank in Multan

1. The Rs. 600,000 is payment in lieu of leave, salary under section 12(2)(a).
2. Taxable salary is Rs. 2,000,000 + Rs. 600,000 = Rs. 2,600,000.
3. Clause (2), slab above Rs. 2,200,000 up to Rs. 3,200,000: Rs. 116,000 plus 20% of Rs. 400,000 = Rs. 116,000 + Rs. 80,000 = Rs. 196,000.

The same Rs. 600,000 costs Bushra Rs. 196,000 - Rs. 94,000 = Rs. 102,000 in extra tax that Asif does not pay.

What if the encashment is paid in a later tax year?

For a private-sector employee, the amount is still salary because section 12(5)(b) covers amounts from a past employer. If it is paid late and, as a result, falls to be taxed at higher rates than in the year the service was rendered, section 12(7) allows an election, by notice to the Commissioner, to be taxed at the rates of the earlier year. Whether leave encashment counts as an amount “paid to an employee in arrears” in a given case is a question of fact the Ordinance does not settle.

What if I take leave instead of encashing it?

Salary paid while on leave is “leave pay” under section 12(2)(a), taxed as ordinary salary. Clause (19) speaks of “encashment”, so it is about the cash sum paid in place of leave, not about salary drawn during leave.

Common mistakes

• Assuming every retiree’s leave encashment is exempt. Clause (19) names three groups only.
• Assuming a government-linked employer is enough. The clause’s text names the Federal and Provincial Governments and the Armed Forces, not corporations or local governments.
• Confusing LPR encashment with gratuity. Gratuity has its own rules and limits under clause (13). They are separate exemptions.

What to check in the official text

Read clause (19) of Part I of the Second Schedule, section 12(2)(a), 12(5) and 12(7), and section 53. If your employer is a corporation or authority, check your service rules and any clarification from the Board, which is not in this corpus, before treating clause (19) as applicable.