Understanding Company Share Option Plans (CSOPs) in the UK

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What is a CSOP?

A Company Share Option Plan, or CSOP, is a specific type of employee share scheme recognised by HM Revenue & Customs (HMRC) in the UK. In simple terms, it gives employees or directors the option – the right, but not the obligation – to buy shares in their company at a fixed price at some point in the future.

The key attraction is that if the scheme meets HMRC’s rules, it offers significant tax advantages compared to receiving shares or options outside of an approved scheme.

Why are CSOPs Becoming More Popular?

Statistics show more UK employers are using CSOPs. They are often used by larger private companies, publicly listed companies, and UK subsidiaries of international businesses.

The UK government encourages these schemes because they help align the interests of employees with those of the company and its shareholders. Recent changes have made them even more attractive:

Increased Limit: An employee can now be granted options worth up to £60,000 (valued at the time of grant) under a CSOP, double the previous limit.
More Flexible Share Rules: Restrictions on the types of shares that can be used have been relaxed, making it easier for more companies to qualify, especially those structured in ways that previously excluded them (like having multiple share classes).

These changes make CSOPs a particularly good alternative for companies that have outgrown the limits of the Enterprise Management Incentive (EMI) scheme or never qualified for it.

Key Features and Benefits of CSOPs

Tax Efficiency for Employees: This is the main draw. If qualifying conditions are met (see below), employees pay no Income Tax or National Insurance when they exercise (buy) the shares. They only potentially pay Capital Gains Tax (CGT) when they later sell the shares, and CGT rates are typically much lower than Income Tax rates. This effectively converts potential employment income into a capital gain.
Tax Benefits for Employers:
- The costs of setting up and running the scheme are usually deductible against the company’s corporation tax bill.
- Crucially, when an employee exercises a qualifying CSOP option, the company can often claim a corporation tax deduction. This deduction is typically equivalent to the Income Tax saving the employee benefits from.
Flexibility for Employers (Discretionary): Unlike some other schemes (like Save As You Earn – SAYE, or Share Incentive Plans – SIP), employers don’t have to offer CSOP options to all employees. They can choose which employees or directors participate and can even offer different terms (within limits) to different individuals. This allows companies to target key staff they want to retain and motivate.
No Upfront Cost for Employees: Employees don’t pay anything when they are granted the option. They only pay the agreed exercise price if and when they decide to buy the shares.
Potential for Significant Upside: If the company’s value increases between the grant date and the exercise date, the employee benefits from that growth, paying only the pre-agreed price for shares that are now worth more.
No Obligation: If the company’s share value doesn’t increase above the exercise price, the employee can simply let the option lapse without any financial loss.

Who Can Use a CSOP?

Company Requirements:

The company issuing the shares must generally be independent (not controlled by another company).
However, CSOP options can be granted over shares in a parent company, even if that parent is based overseas, provided the parent company’s shares meet the criteria. This makes CSOPs useful for UK subsidiaries of foreign groups.
The company cannot be an unquoted subsidiary of a quoted parent company.
There’s no restriction based on the company’s trade or requirement for it to trade primarily in the UK.

Employee Requirements:

To receive the tax benefits, the individual must be an employee or a full-time director (working at least 25 hours per week) of the relevant company.
The employee (along with their close associates) must not have a “material interest” in the company. Broadly, this means controlling more than 30% of the ordinary share capital.
It’s possible for an employee to hold both EMI options and CSOP options in the same company, provided the relevant limits for each scheme are respected.

How CSOPs Work in Practice

Granting the Option: The company grants an option to an employee via a written agreement. This agreement specifies:
- The date the option is granted.
- How many shares the option covers.
- The exercise price per share (the price the employee will pay). For tax advantages, this must normally be at least the market value of the shares on the grant date.
- When and how the option can be exercised (e.g., after a certain period, or only on an exit event like a company sale).
- Any performance conditions that must be met before exercise.
- Any restrictions on the shares once acquired.
Valuing the Shares:
- Unquoted Companies: The market value at grant needs to be agreed with HMRC. Often, a valuation based on fiscal principles (which can sometimes be lower than a purely commercial value) is used. Discounts might be applicable depending on the share class and rights.
- Quoted Companies: The value is typically based on the listed market price on the grant date.
The Waiting Period: To get the full tax benefits, employees generally need to hold the option for at least three years from the grant date before exercising it. Exceptions apply for ‘good leavers’ (e.g., due to redundancy, injury, disability, retirement, or death).
Exercising the Option: The employee decides to buy the shares at the pre-agreed exercise price. If the scheme qualifies and the holding period is met, no Income Tax or National Insurance is due at this point.
Selling the Shares: When the employee later sells the shares, any profit they make (the difference between the sale price and the exercise price) is subject to Capital Gains Tax (CGT).

Understanding Dilution

When new shares are issued to employees exercising CSOP options, the total number of shares in the company increases. This means that each existing share now represents a slightly smaller percentage of the overall company. This is called dilution.

Example: Imagine a company has 1,000 shares owned by existing shareholders. It grants CSOP options over 100 new shares. If all options are exercised, there will be 1,100 shares in total. Someone who originally owned 100 shares (10% of the company) now owns 100 shares out of 1,100, which is just over 9% of the company.

Protecting Existing Shareholders from Excessive Dilution:

While CSOPs inherently involve some dilution (which is the ‘price’ of incentivising employees), existing shareholders need control over how much dilution they accept. Protection is usually achieved through:

Shareholder Approval: Setting up a CSOP and determining the total number of shares available under the plan (the ‘option pool’) typically requires approval from the existing shareholders.
Defining the Option Pool Limit: Shareholders agree on a maximum number or percentage of the company’s share capital that can be allocated to the CSOP. This sets a clear ceiling on potential dilution from the scheme. This limit is often documented in the company’s articles of association or a shareholders’ agreement.
Clear Documentation: Formal scheme rules and tracking (e.g., using share capital tables) help monitor the options granted and exercised against the agreed limits.

This ensures that dilution is managed and doesn’t exceed levels agreed upon by the owners of the business.

CSOP vs. Growth Shares: A Detailed Comparison

Another way to incentivise employees, particularly senior management, is through Growth Shares. These are different from options.

What are Growth Shares? Growth Shares are a special class of actual shares issued to employees. They typically only benefit from the growth in the company’s value above a certain pre-agreed hurdle or threshold. Employees usually buy these shares upfront, often at a low initial price because their current value (without future growth) is minimal due to the hurdle.

Here’s how CSOPs and Growth Shares compare:

Feature	CSOP (Company Share Option Plan)	Growth Shares
Mechanism	Right (option) to buy shares later.	Actual purchase of a special class of share upfront.
Upfront Cost	None for employee at grant.	Employee pays purchase price (can be low).
Tax at Acquisition/Exercise	No Income Tax/NI if qualifying conditions met (esp. 3-year hold).	Usually No/Low Income Tax if purchased at correct market value (reflecting the hurdle). Risk of tax if HMRC deems them undervalued at purchase.
Tax on Sale	Capital Gains Tax on profit (Sale Price – Exercise Price).	Capital Gains Tax on profit (Sale Price – Purchase Price).
HMRC Approval	Required for tax advantages (provides certainty).	Not formally approved. Relies on correct structuring and valuation. Higher risk of HMRC challenge.
Value Limit	Options up to £60,000 grant value per employee.	No statutory limit, but practical limits from valuation and dilution.
Employee Eligibility	Must be employee/full-time director. No “material interest” (30%).	More flexible – can sometimes include non-execs, consultants. Material interest rules may not apply depending on structure.
Company Eligibility	Independent co. or parent shares. No unquoted sub of quoted parent.	Generally flexible, depends on ability to create new share class.
Share Type	Must be ordinary, fully paid-up, non-redeemable.	Specifically created class with hurdle-based rights.
Complexity	Standardised framework, HMRC rules. Valuation needed.	Requires careful legal drafting of share rights. Valuation is critical and complex.
Dilution	Occurs when options are exercised in the future.	Occurs when the Growth Shares are initially issued.
Holding Period	3-year rule generally needed for tax benefits.	No statutory minimum hold for CGT, but usually held until exit.
Certainty	Higher tax certainty due to HMRC approval.	Lower tax certainty, reliant on valuation/structure.

When Might You Choose CSOP vs. Growth Shares?

CSOP: Often better for broader employee participation, where tax certainty is paramount, and when the £60,000 limit per employee is sufficient. Good for companies wanting a well-understood, HMRC-approved structure.
Growth Shares: Often favoured for key senior management or founders where larger stakes (beyond CSOP limits) are desired, and the focus is purely on significant future growth. Suitable when the flexibility to include non-employees or those with material interests is needed, accepting the higher complexity and valuation risk.

Potential Pitfalls and How to Avoid Them

A poorly designed or communicated CSOP can backfire:

Unexpected Tax Bills: If the scheme rules aren’t met (e.g., options exercised too early), employees could face unexpected Income Tax and NI, leading to resentment.
Unhappy Shareholders: If dilution isn’t properly managed and agreed upon, existing shareholders may feel their stake has been unfairly reduced.
Difficult Leavers: Rules need to clearly state what happens to options if an employee leaves under different circumstances (‘good’ vs. ‘bad’ leavers).
Blocking Decisions: If employees become shareholders with significant voting rights and aren’t aligned with majority shareholders, they could potentially hinder company decisions or a future sale.

Avoiding problems requires careful planning:

Clear Scheme Rules: Professionally drafted rules covering eligibility, exercise conditions, leaver provisions, etc.
Accurate Valuation: Agreeing the market value with HMRC upfront for unquoted companies is vital.
Shareholder Agreement: Ensuring existing shareholders understand and consent to the potential dilution.
Good Communication: Explaining the scheme clearly to employees – how it works, the potential benefits, the tax implications, and any conditions – is crucial for motivation and managing expectations.

CSOPs for International Companies

Foreign parent companies expanding into the UK often find CSOPs an effective way to incentivise their UK-based employees. Options can be granted over the parent company’s shares, provided those shares meet the requirements. The terms often mirror the company’s global share plans but must be adapted to comply with UK tax law and HMRC rules for CSOPs. Specific UK ‘sub-plans’ or addendums are often created.

In Conclusion

CSOPs offer a tax-advantaged and flexible way for UK companies, including subsidiaries of overseas parents, to reward and retain key employees and directors. By granting options with significant tax benefits upon exercise, they align employee interests with company growth. While less suitable for very small start-ups (where EMI is often better) or for granting very large stakes (where Growth Shares might be considered), the recent enhancements to CSOPs make them an increasingly attractive and valuable tool for a wide range of businesses looking to motivate their workforce. Careful planning and clear communication are key to ensuring the scheme is successful for both the company and its employees.