A subsidiary is a company that another company owns or controls. We call it the parent company or holding company. The parent company owns at least 50% of the voting stock, i.e., it has a controlling interest.
The subsidiary may be a limited liability company, a corporation, or a business that belongs to the state.
Many holding companies own business entities abroad. Those subsidiaries must follow the laws of the host nation. In other words, they must comply with the rules and regulations of the country where they operate.
Subsidiary is a separate legal entity
Subsidiaries are separate, distinct legal entities for taxation purposes. They are not like a divisions, for example, which are businesses that are part of the main company.
If you sue a subsidiary, the holding company is not legally liable.
Companies use the separate legal structure to gain certain tax benefits. In this way, they can also monitor the results of a distinct business unit and isolate risk from the rest of the corporation.
Having a separate legal structure is useful when you want to prepare for the sale of certain assets.
Lawyers can sometimes go to court and make the parent company liable when a subsidiary becomes insolvent. However, they must pierce through the corporate veil. In other words, they must show that the parent and subsidiary are no more than alter egos of each other.
Benefits of establishing subsidiaries
- The subsidiary benefits from the holding company’s financial resources and name recognition.
- For employees, there may be promotional and cross-training opportunities. These benefits were not available before the new affiliation.
- The holding company does not require shareholders’ approval to move forward with establishing subsidiaries. This is not the case with mergers.
- Establishing a subsidiary is considerably cheaper than a merger.
- Globally, forming or acquiring subsidiaries overseas generates goodwill in markets that might not otherwise be amenable to doing business. It also offers tax advantages.
If a subsidiary needs to improve its credit rating, it may ask the parent company for a keepwell agreement. In a keepwell agreement, the parent company promises to keep the subsidiary solvent for a specific period. Keepwell agreements tend to boost subsidiaries’ creditworthiness.
Subsidiary vs. Affiliate
An affiliate or associate is a company whose parent only owns a minority stake. Holding companies own a controlling stake in the subsidiary.
For example, Berkshire Hathaway wholly owns Fruit of the Loom, Dairy Queen and NetJet. Therefore, they are subsidiaries. However, American Express, IBM, and Wells Fargo are affiliates, because it has significant minority holdings in them.
In the United States, for the holding company to submit consolidated tax returns, it must own at least 80% of the subsidiary.
Banks and multinational corporations use a strategy known as foreign direct investment. They create subsidiaries or affiliates to break into a target market. They do this because they would find much more difficult if they used their main name.
Etymology of subsidiary
Etymology is the study of where words came from and how they evolved.
Etymologists say that the term ‘subsidiary’ comes from the Latin subsidiarius meaning ‘reserved, of a reserve, belonging to a reserve; supplement, or serving to assist.’
Subsidiarius came from Subsidium, meaning ‘a help, troops in reserve, aid.’ As a noun with its modern meaning in the English language, the term appeared in Britain during the 1600s.
In the United States, operating subsidiaries are commercial enterprise that operate with their own identity. Non-operating subsidiaries, on the other hand, use the identity of their holding company.
In the world of business, subsidiaries are extremely common. Virtually every multinational corporation organizes its operations with subsidiaries.
For example, Berkshire Hathaway, based in Omaha, Nebraska, wholly owns many companies. It owns NetJets, FlightSafety International, Helzberg Diamonds, and Fruit of the Loom. It also fully owns Dairy Queen, Lubrizol, BNSF, and GEICO. The company has significant minority holdings in the Kraft Heinz Company, American Express, and Coca-Cola.
Video – Accounting for Subsidiaries
In this video, Dr. Dave Bond gives us an overview of the key elements of the initial investment by a holding company in a subsidiary.