CSOP share options and the US return

How does the UK tax a CSOP option

CSOP is a discretionary UK plan in which the company chooses which employees and directors receive options. If an option is exercised under the plan rules at least three and no more than ten years after grant, there is normally no income tax or National Insurance on the spread. Capital gains tax may apply on sale.

GOV.UK's guidance on employee share schemes (opens the official GOV.UK page in a new tab) sets an individual limit on the market value, measured at grant, of the shares under unexercised CSOP options that one person may hold. HMRC's manual adds that the price must be fixed at grant and must not be manifestly less than the market value of the shares at that time. An option priced at a discount falls outside the plan. Someone with a material interest in the company cannot take part.

On a sale, HMRC's manual sets the base cost as the price paid plus any amount already charged to income tax, and the acquisition date is normally the exercise date. The general rules on tax when you sell shares (opens the official GOV.UK page in a new tab) and Capital Gains Tax (opens the official GOV.UK page in a new tab) then apply. Our UK Self Assessment service reports the gain on the SA100 return.

• Grant: no UK income tax where the price is not below market value
• Exercise between the third and tenth anniversaries of grant: no income tax or National Insurance
• Exercise by a good leaver within six months of leaving: relief kept, if the plan allows
• Exercise on certain company events set out in the legislation and the plan rules: relief kept
• Sale of the shares: capital gains tax on the growth from the price paid

What happens if a CSOP option is exercised early

The UK relief can be lost. HMRC's manual lists the exceptions: a good leaver exercising within six months of leaving, exercise after death within twelve months, and certain company events in the legislation. Outside those, an exercise before the third anniversary may bring a UK income tax charge on the spread at exercise.

The manual names redundancy, injury, disability and retirement as the good leaver reasons a plan can specify, and notes that illness on its own is not one of them. A plan does not have to include every reason, so the option agreement decides what applies. Leaving for another job before the third anniversary is usually outside the exceptions.

For a US citizen, losing the relief can make the two returns line up. The UK then taxes the spread as employment income in the same year the US taxes it as compensation, both in the general category, and the UK tax can usually be credited against the US tax on the same income. That does not make early exercise worth choosing, but it shows the CSOP mismatch comes from the relief itself.

How does the IRS treat a CSOP option

Usually as a nonstatutory option. The US gives special status only to incentive stock options and options under an employee stock purchase plan, both defined by the US tax code. A CSOP is drafted around HMRC's conditions, so unless it also meets the US ones, the IRS applies the ordinary rules for options granted for services.

Publication 525 says a nonstatutory option without a readily determinable fair market value is not taxed at grant. Many CSOP options are over listed shares, but the option itself is not traded and cannot be transferred, so it rarely meets that test. The US charge falls at exercise, on the market value of the shares less the price paid. An employer granting incentive stock options issues Form 3921 (opens the official IRS page in a new tab) after each exercise, which a UK company running a CSOP does not usually do.

The market value price is one point where CSOP differs from EMI. Because a CSOP option cannot be granted at a manifest discount, it is less likely to raise the US deferred compensation question that discounted EMI grants can. An HMRC-agreed value and a value that satisfies US rules need not be identical, so our private client service reviews the grant papers where the shares are unlisted.

Which workdays source the CSOP spread

The spread is sourced by where the employee worked between grant and the date all employment conditions for exercise were met. The share earned by days outside the US is foreign-source, and only that share can support a credit for UK tax. Work done after the option becomes exercisable does not count.

The US sourcing regulations treat that period as the one to which option compensation relates, and an example in them excludes services after the option becomes exercisable. Many CSOP plans make options exercisable from the third anniversary, to match the UK window, so the period is often three years. Some plans add performance conditions or a different vesting date, and the plan rules decide.

This differs from EMI, where many options vest only on an exit and the period can run for years. A CSOP period is usually fixed and shorter, which makes the workday count easier to reconstruct but no less likely to straddle a move. The method is the one our post on RSUs when you move between the US and the UK describes, applied to the spread at exercise.

Why the UK and US bases differ after exercise

Each country starts the shares from a different figure. The UK base cost for a relieved CSOP exercise is usually just the price paid. The US basis is the price paid plus the spread already taxed as compensation, both in dollars at the relevant dates. The same growth is therefore US income at exercise and a UK gain on sale.

Publication 525 sets the US basis as the amount paid plus any amount included in income, and the later sale goes on Form 8949 (opens the official IRS page in a new tab) with the holding period starting at exercise. The UK computation runs in sterling from the exercise price. Because the two bases are measured in different currencies on different dates, the US gain can differ from the UK gain even where the shares are sold soon after they are acquired.

The foreign tax credit (opens the official IRS page in a new tab) matches foreign tax to income by category and by year. Publication 514 (opens the official IRS page in a new tab) places compensation in the general category, while a gain on shares is generally passive, so UK capital gains tax may find little US tax of the right kind to offset. Unused credits carry back one year and forward ten within the same category, claimed on Form 1116, and our post on which year takes the UK tax credit explains the timing choice.

A CSOP exercise on a US citizen's return

The spread appears as compensation on the US return for the year of exercise, with no matching UK tax where the UK relief applies. The later sale is a US capital gain or loss on the growth since exercise, and a UK gain on the growth since the price paid.

Consider a US citizen employed in Bristol by a UK-listed engineering group, working only in the UK, whose CSOP options become exercisable on the third anniversary. She exercises soon after and keeps the shares. The US taxes the spread as foreign-source compensation on Form 1040, with excess credit from UK tax on her salary possibly absorbing some of it. When she sells two years later, the UK charges capital gains tax on the whole growth from her price, payable by 31 January after the UK tax year ends, while the US gain is only the growth since exercise.

Whether that UK tax can be credited depends on the categories, the years and her other income, which our cross-border treaty relief service models before exercise. Our individual tax returns service prepares both returns from the same records, and the guide to US-UK tax for founders, fund managers and executives covers the other share plans. Our post on Sharesave and SIP shares for US citizens covers the all-employee plans.

• The option agreement, plan rules and any performance conditions
• The market value agreed or used at grant, and how it was set
• A workday calendar by country from grant to the date the option became exercisable
• Exercise and sale dates, share values and exchange rates on each
• Any leaver letter or company event notice that affected the timing