Understanding Subsidiaries

A subsidiary is a company owned by a larger corporation, typically referred to as the parent company or holding company, which holds controlling ownership of the subsidiary. If a subsidiary is wholly owned by a larger company, it's called a wholly-owned subsidiary. In most cases, subsidiaries are legally and financially independent of their parent companies but still subject to significant control from them. By acquiring numerous subsidiaries, a parent company may evolve into a corporate group.

What Is a Subsidiary?

A company becomes a subsidiary when a holding company acquires more than half of its shares. While a subsidiary can have multiple owners, it can only have one parent company. When the parent company owns 100% of the subsidiary's shares, it's termed a "wholly-owned subsidiary."

Subsidiaries can also act as parent companies to other subsidiaries, and some large corporate structures may require multiple layers of subsidiaries.

Large corporations may have multi-tiered subsidiaries both in the United States and worldwide. Besides having subsidiaries domestically, companies like Microsoft also have multiple subsidiaries worldwide to conduct business in specific countries/regions. For instance, Microsoft de Argentina S.A. in Argentina and Microsoft Deutschland GmbH in Germany.

What Is the Purpose of Subsidiaries?

Subsidiaries serve as a means for achieving the goals of the parent company. Some common reasons why a parent company chooses to establish or acquire subsidiaries include:

Tax advantages: Parent companies can offset profits earned from one subsidiary against losses incurred by another, effectively reducing their taxable income. Additionally, some locations offer more tax incentives than others. Hence, subsidiaries might be established in different locations from their parent companies to take advantage of local tax benefits.

Streamlined operations: Subsidiaries in specific countries or regions can oversee local operations more effectively than the parent company situated on the other side of the globe.

Liability reduction: By transferring ownership and management of certain assets to subsidiaries, parent companies often retain limited liability associated with those assets. In the commercial real estate industry, for example, parent companies frequently establish limited liability companies (LLCs) as subsidiaries to purchase and operate large assets like warehouses or downtown office buildings.

Specific assets: Sometimes, acquiring a subsidiary is to obtain intangible assets. When a parent company only needs to acquire a company with specific assets and establishes it as a subsidiary, the parent company doesn't have to attempt to replicate a successful model.

How Do Subsidiaries Operate?

To establish a subsidiary, the parent company must hold more than half of its shares, and a key characteristic of a subsidiary is the parent company's control over its operations.

If ownership of a company is less than half, it's not considered a subsidiary but rather termed an associate or affiliate. This is an important distinction as the financial reporting rules for subsidiaries differ from those for associates.

Best practice is to seek advice from a Certified Public Accountant (CPA) experienced in intercompany asset and liability transfers and familiar with both national and local tax laws applicable to parent and subsidiary companies.

Assets and liabilities of the parent company are usually kept separate from those of the subsidiary, shielding them from claims of responsibility and creditors. This means that if a subsidiary defaults on a loan, creditors of the subsidiary typically cannot go after the parent company's assets.

How Are Subsidiaries Established?

Initially, the establishment of a subsidiary must receive authorization from the current management of the parent company. The entire process should be well-documented, and a vote taken to decide on the establishment of the subsidiary. Once management secures majority approval for the establishment, the company's board of directors formally decides in the signed documents.

The two most common types of business entities for subsidiaries are corporations or limited liability companies. Both these business entity types generally provide creditor protection and allow the parent company to hold controlling interests in the subsidiary, though rules governing the registration or organization of LLCs vary by locality.

However, some common rules apply, such as selecting a unique name and registering an official mailing address. Consult a CPA and visit the Secretary of State's website for all relevant details in your locality.

How Do Subsidiaries Operate?

Parent companies typically acquire controlling interests in subsidiaries by providing startup capital, which helps fund the initial operations.

Parent companies usually draft the bylaws for subsidiaries, establish formal rules for internal management of the subsidiary, and outline the ownership role of the parent company. General bylaws prohibit changes to the bylaws without approval from the parent company.

Once the parent company elects and establishes a board of directors for the subsidiary, the board can operate as an independent entity, functioning much like a typical standalone enterprise.

Financial reporting for subsidiaries is separate from that of the parent company. However, the parent company usually consolidates the subsidiary's financial statements, including balance sheets and income statements, into the parent company's financial statements.

Why Create a Subsidiary?

Ownership of subsidiaries by the parent company ensures that the board acts in the best interests of the parent company and retains independent financial reporting.

However, the parent company can merge the two sets of books to offset profits and losses, reducing applicable income taxes at local and national levels.

In addition to tax advantages and protection from creditors and litigants against the subsidiary, subsidiaries can offer benefits to the parent company such as streamlined operations and competitive advantages through assets, equipment, or their research and development departments.

What Are the Advantages and Disadvantages of Subsidiaries?

One of the most significant advantages of subsidiaries is the opportunity to treat the parent and subsidiary as separate entities. Through this limited liability, parent companies typically bear no legal responsibility for the debts and liabilities of the subsidiary.

The liability of the parent company usually extends only to the initial capital exchanged for company stock and controlling interests. As long as there are clear distinctions between the businesses of the parent and subsidiary, the assets of the parent company are usually protected from creditors.

This carefully considered investment allows the parent company to continue seeking other growth opportunities.

On the other hand, two prominent disadvantages are the significant amount of necessary paperwork and bureaucracy that come with a larger organization. To truly maintain independence between the two entities, each board of directors needs to operate independently, potentially leading to longer wait times for consensus and implementation of decisions.

How Do Subsidiaries Differ from Other Corporate Structures?

Here are some common terms similar to subsidiaries:

Associates: When a parent company owns less than a majority stake, the company is termed an associate, and the parent company holds less than half of the company's shares.

DBA: Unlike a subsidiary, a DBA is not an independent company. It's the same company doing business under a different name ("doing business as").

Branches or divisions: Branches or divisions refer to parts of a company operating at locations other than the headquarters, and the company is a standalone entity.

Sister companies: All sister companies are subsidiaries, but not all subsidiaries are sister companies. Sister companies refer to subsidiaries associated with each other because they share the same parent company. However, a parent company may have only one subsidiary, in which case, that subsidiary has no sister companies.

Holding companies: The term for a parent company is a holding company. Holding companies hold enough shares of subsidiaries to have controlling interests but do not involve themselves in the day-to-day operations of the subsidiaries.