S77 Finance Act - Financial Solutions

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Section 77 of the UK’s Finance Act 1986 is a crucial piece of legislation concerning the taxation of company share options. It primarily focuses on situations where an individual acquires shares in a company as a result of exercising a share option, and specifically addresses potential income tax liabilities arising from that exercise.

Before Section 77, employees exercising share options could effectively avoid income tax on the difference between the market value of the shares at the time of exercise and the price they paid (the exercise price). This was because the gain could be treated as capital gains, taxed at a lower rate. Section 77 aimed to prevent this perceived tax avoidance by ensuring that, under certain circumstances, this gain would be taxed as income.

The core principle of Section 77 is to treat the “chargeable event” (typically the exercise of the option) as giving rise to taxable income if certain conditions are met. The key condition is the existence of a “material interest” held by the employee (or certain connected persons) in the company granting the option. Material interest, broadly speaking, signifies a significant degree of control or ownership within the company.

The definition of “material interest” has been subject to refinement and interpretation over time, but it generally revolves around the individual (or their associates) possessing 25% or more of the ordinary share capital, the voting rights, or the assets available for distribution in a winding up. If an individual has a material interest *before* or *after* exercising the option, Section 77 can apply.

When Section 77 applies, the taxable benefit is calculated as the difference between the market value of the shares at the time of exercise and the exercise price paid by the employee. This difference is then treated as employment income, subject to income tax and National Insurance Contributions (NICs) through the PAYE system. This is a significant departure from capital gains treatment, often resulting in a higher tax burden for the individual.

It’s important to note that Section 77 doesn’t apply to all share option schemes. It is primarily targeted at situations where individuals with significant influence over the company are granted share options, potentially exploiting the tax advantages. Approved share option schemes, such as Enterprise Management Incentives (EMI), often have specific provisions that exempt them from the application of Section 77, provided they meet certain requirements.

The complexities surrounding Section 77 necessitate careful consideration when designing and implementing share option schemes. Companies and employees alike should seek professional advice to understand the potential tax implications and ensure compliance with the legislation. Failing to properly assess and manage the risks associated with Section 77 can lead to unexpected tax liabilities and penalties.