Operating Subsidiary Definition
A registered business entity partly owned (50% +) or fully owned (100%) by another company is called a subsidiary. The owning company can be referred to as the holding company or a parent company. A subsidiary operates independently from the owning company whose role is limited to oversight only. Also, subsidiaries can be related by virtue of being owned by the same parent/holding company, in such instance, the subsidiaries are referred to as sister companies.
A holding company is one that doesn’t have a business operation but simply ‘holds’ controlling or minority shares as well as assets in other companies. In contrast, a parent company does have a business operation and can own minority or controlling stocks in others companies with similar business operation in terms of product and services or it can be a different line of business altogether.
A subsidiary is often confused with a branch/division or an affiliate/associate company, but they are different. In contrast, a division or branch is the same company but providing its services in several different geographical locations. For example, McDonald’s has several branches or business division spread out across the United States.
An affiliate or an associate company, on the other hand, can be more confusing a times. In the context of ownership, it may refer to a company where the parent company controls less than fifty percent of the business. Whereas, in commerce, it may refer a contractual agreement, where a small business agrees to be ‘associated’ or ‘affiliated’ to another company to achieve a common goal such as selling or manufacturing a product.
A Little More on What is a Subsidiary Company
A subsidiary can be a smart vehicle to focus on a specific aspect of a business, penetrate new markets or a strategy to segregate part of a business that is risky. Also, for family-owned business creating subsidiaries may be a strategy to distribute the wealth to different family members in the future to avoid family wrangles.
In addition, subsidiaries are also a tool to raise capital by selling stocks in the subsidiary without affecting the parent company. Further, they help in reporting disclosures by keeping some of the parent or company line of business that are not suitable for public investment and disclosure requirements.
Nevertheless, Legal protection and related tax benefits are major reasons why a company would create a subsidiary; an operating subsidiary is a separate legal entity and totally independent in terms of its liabilities, taxation, and governance from the parent or holding company. However, the owning company can influence the running of the subsidiary because of majority ownership that bestows a lot of power in the election of a subsidiary’s board of directors and its functioning.
The parent or holding company’s powers can be classified either in terms of ownership or control. Ownership occurs when a company owns more than fifty percent of the shares of the subsidiary. Control is usually in case of a public listed company, where a company can be the largest shareholder with even a ten percent shareholding.
Characteristics of a Subsidiary Company
Some of the identifiable features of a subsidiary include:
- Being a separate legal entity, a subsidiary can sue and can be sued.
- A subsidiary is independent in terms of its liabilities, taxation, and governance.
- It doesn’t need to have the same line of business as the parent company or operate in the same geographical location.
- An operating subsidiary can also own other subsidiaries creating multiple levels of subsidiaries either a first tier, second tier or even a third-tier subsidiary line.
- Decisions by the subsidiary can be influenced by the parent company through the board due to a majority voting right.
- Has a separate financial accounting from the parent/ holding company; own ledger, profit, and loss statements, as well as tax filing obligations.
- Should have a separate bank account from the parent company.
- Has a separate payroll with the parent company with each paying their employees differently the relationship notwithstanding.
- A subsidiary does not need to pay the income tax; instead it can pass the tax burden to the owning company.
- A subsidiary and the Parent or holding company can have shared directors on the respective board.
- A subsidiary’s business plans and financial data can be accessed by the parent company at any time, to check on progress and protect its interests.
Generally, from an accounting and legal standpoint subsidiaries are complex to administer. They can have a consolidated financial reporting together with the parent company or can decide not to consolidate its accounting too. For regulatory reasons, unconsolidated subsidiary firms are typically those that the parent or holding firm does not have a majority stake.
The Securities and Exchange Commission (SEC) requires all public companies to generally consolidate all majority-owned firms or subsidiaries. Only in rare cases does the SEC allow majority-owned subsidiary not be consolidated such as when a subsidiary is facing bankruptcy.
How to Create a Subsidiary
There are costs involved in the creation of a subsidiary, so it is advisable to do so at early stages of a business growth when such costs are minimal as compared with the resulting tax relief and other benefits. Below are the steps to set up a subsidiary:
- Ensure that the business doesn’t have any pending litigation in court.
- Change the ownership structure of the business if it is a sole proprietorship to a limited liability company (LLC)
III. Since the parent company is now an LLC, the subsidiary to be set up will be an LLC subsidiary. Visit the secretary of state’s website and perform a name search using your preferred subsidiary name.
- Get an Articles of Organization that is modeled preferably from the parent company’s documents. It is advisable to get a professional attorney to render assistance.
- Draft an operating agreement detailing the type of business formation, managerial structure, and responsibilities among others.
- File the Articles of Organization for registration with the appropriate government agency.
VII. Capitalize the subsidiary by transferring assets so it can start operations and in exchange for the company’s ownership interest.
VIII. Apply for an Employer Identification Number (EIN) from the Internal Revenue Service (IRS). Use this number on all subsidiary business documentation, such as tax returns, business banking and invoicing
- Get any mandatory license or permit required by the local authority in order for the subsidiary to legally operate.
A parent company can form an unlimited number of subsidiaries. Public companies are required by the SEC to disclose all subsidiaries under Item 601 of Regulation S-K. For instance; General Motors has over fifteen hundred subsidiaries in Delaware alone. Warren Buffett’s Berkshire Hathaway, on the other hand, has over two hundred and fifty subsidiaries.
Benefits of a having a Subsidiary
Some of the advantages of setting up a subsidiary include:
- Tax benefits – An owning company has the advantage of getting reduced tax liability. Income liability from gains made by one subsidiary can be offset by losses in other subsidiaries.
- Risk reduction – the separation of a subsidiary as a separate legal entity means that losses incurred by a subsidiary do not readily transfer to the parent company.
- Business focus – creating a subsidiary can be a strategic way a parent company could create brand awareness of a specific product from their multiple products or services.
- It’s easier for an operating subsidiary to collaborate with other companies in a joint venture, merger, or even partnership. As a result, using a subsidiary to spin off a particular venture can be an effective and profitable way to maximize shareholder value.
- A separate management means a parent company can link executive pay to the economic performance of a particular subsidiary company.
- Establishing a foreign subsidiary also enables a parent company to expand its target consumer and to introduce its products and services to a new group of prospects.
- A profitable subsidiary means a parent company receives dividends which can be a source of capital for business growth.
- An international subsidiary means might not pay income taxes in the United States. Alternatively, it may pay but might do so at a lower rate in the where they are located.
Drawbacks to Subsidiary Company
Setting up a subsidiary also has some disadvantages:
- Bureaucracy can hinder the independence of subsidiary since decisions have to pass through the parent company making the chain of command for decision-making somewhat tedious.
- There tends to be lengthy and costly legal paperwork involved with a subsidiary especially information as well as in tax filing.
- Limited control over a subsidiary by the parent company may result in limited access to the cash flow information.
- Sometimes, the reputation of the parent company is linked to that of the subsidiary, and the parent company may need to pay off the debts of the subsidiary to save face.
- The parent company may need to guarantee the loans of its subsidiaries, thereby directly exposing itself to the liabilities of its subsidiaries.
- The parent company may still be liable for the action of the subsidiary in the event of a claimant executing an adverse legal judgment.
References for Subsidiary Company
Academic Research on Operating Subsidiary
- The OCC Operating Subsidiary Regulation: Legal Authority Supporting Promulgation or Legal Fiction, Massey, P. L. (1997). YB Int’l Fin. & Econ. L., 2, 457. The paper discusses the OCC regulations on subsidiaries on a legal standpoint in particular the legal authority supporting the promulgation of the rules which have been criticized as being a legal fiction.
- Adjustable-rate mortgage regulation update, 7 American National Bank of Austin, application to establish an operating subsidiary. 36 Application: by American …, Conover, C. The paper discusses the adjustable mortgage regulation and how it has influenced almost thirty six applications by seven American national banks of Austin to establish subsidiaries.
- Is a State-Chartered Nonbank Operating Subsidiary Equivalent to a National Bank for Purposes of Federal Preemption (05-1342), Jones, B. L. (2006). Preview US Sup. Ct. Cas., 34, 143. The article tries to examine whether a state-chartered nonbank operating subsidiary is equivalent to a national bank for purposes of the United States federal preemption.
- Valuation of the operating flexibility of multinational corporations, Allen, L., & Pantzalis, C. (1996). Journal of international business studies, 27(4), 633-653. The paper looks at the value of multinationals having subsidiaries as a means for foreign operating flexibility and tries to present the characteristics of the return to multi-nationality.
- Procedural justice, attitudes, and subsidiary top management compliance with multinationals’ corporate strategic decisions, Kim, W. C., & Mauborgne, R. A. (1993). Academy of management journal, 36(3), 502-526. The study looks at attitudes by top management and procedural justice and how they are in compliance with corporate strategic decisions by subsidiaries owned by multinationals. The study looks at two-stage longitudinal data, suggest that procedural justice enhances subsidiary top managers’ compliance directly and indirectly, through the attitudes of commitment, trust, and outcome satisfaction.
- Insulation from liability through subsidiary corporations, Douglas, W. O., & Shanks, C. M. (1929). The Yale Law Journal, 39(2), 193-218. The paper presents the primary motives to companies setting up subsidiaries. The paper asserts that factors such as avoidance of taxation, avoiding complexities of qualifying as foreign companies in some states and purchasing assets and many others.
- Bank performance around the introduction of a Section 20 subsidiary, Cornett, M. M., Ors, E., & Tehranian, H. (2002). The Journal of Finance, 57(1), 501-521. The paper examines the performance of commercial banks after the introduction and establishment of a Section 20 subsidiary allowing them to conduct investment‐banking activities since 1987.
- Managing subsidiary knowledge creation: The effect of control mechanisms on subsidiary local embeddedness, Andersson, U., Björkman, I., & Forsgren, M. (2005). International Business Review, 14(5), 521-538. The paper presents a hypothesis model on managing subsidiary knowledge creation based on a dataset of MNC subsidiaries in Finland and China. The paper hypothesizes that a subsidiary’s local embeddedness is influenced by headquarters’ use of different control mechanisms which is an important antecedent to a subsidiary’s level of knowledge creation.
- Incentive compatible regulation of a foreign-owned subsidiary, Gresik, T. A., & Nelson, D. R. (1994). Journal of International Economics, 36(3-4), 309-331. The article examines transfer prices for international transfers that provide the means for multinationals subsidiaries to redistribute costs and increase global profits within the givens variations in national tax and profit repatriation policies.
- MNC knowledge transfer, subsidiary absorptive capacity, and HRM, Minbaeva, D., Pedersen, T., Björkman, I., Fey, C. F., & Park, H. J. (2003). Journal of international business studies, 34(6), 586-599. The research examines the relationship between multinational corporations (MNCs) subsidiaries and their human resource management practices. The findings- which is based on data from 169 subsidiaries of MNCs operating in the USA, Russia, and Finland – suggests that ability and motivation are vital in transferring knowledge to related subsidiaries.
- Taxes and the division of foreign operating income among royalties, interest, dividends and retained earnings, Grubert, H. (1998). Journal of Public economics, 68(2), 269-290. The paper looks at how taxes impact on the way U.S. corporations divide foreign affiliate operating income among royalties, dividends, interest, and retained earnings. The paper asserts that taxes discourage repatriation of foreign income and payments of dividends, royalties, and interest.