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Understanding Subsidiaries

By
Lia Kopin-Green
/
January 18, 2023
Last reviewed by
Boruch Burnham, Esq.
/
June 21, 2023

From single-purpose shell companies formed to facilitate a single transaction to large multinational corporations with global operations, subsidiaries are used for a vast array of purposes.

In this guide, we will discuss the various types of subsidiaries, including their uses and benefits, as well as the role of their parents, the extent of parental control over a subsidiary, and their involvement, if any, in the subsidiary’s day-to-day business operations. 

What is a subsidiary?

To understand what a subsidiary is, it may help first to understand what a parent is. In the most basic terms, a parent is an entity that controls another entity (the subsidiary). Note that as a general matter, neither parents nor subsidiaries need to be corporations; they can also be partnerships, LLCs, or joint ventures (JVs) that seek to form a subsidiary to assign and apportion levels of ownership and control over the venture based on their respective contributions in services, assets, ownership, goodwill, etc., For this reason, the term “entity” is generally used throughout this guide rather than the more commonly used “corporation.” 

The aspect of control is important because there is a common misconception that a parent must own more than 50 percent of the subsidiary. However, a parent may establish control even if it is a minority owner if it has more than 50 percent of the voting shares. Furthermore, there are other ways a parent company may exert control over a subsidiary even without a majority of the voting shares, for example, through contractual agreements between the investors and other stakeholders or by having enough representation on a subsidiary’s board of directors to establish veto powers over its decision-making processes. 

Because the extent of a parent’s involvement and control over a subsidiary can widely vary, the parent can affect the composition of a subsidiary’s board based on its particular needs and goals. Therefore, if a parent wants extensive control and decision-making over the subsidiary and its operations, it may appoint a committee to serve on the subsidiary’s board of directors that reports directly to the parent. 

On the other hand, if the parent wants the subsidiary to have more autonomy and flexibility to operate relatively independently (for example, when the parent is a dormant holding company of a large subsidiary that has extensive business operations and maintains its own manufacturing, sales, and operating teams), they may have a board composed of independent directors that report to entities or management within the corporate structure rather than directly to the parent. 

Types of subsidiaries and their uses 

First off, it’s important to distinguish between active and dormant entities. Active entities are those that conduct regular business operations, generate revenue, and provide goods or services to customers or clients. Dormant entities, on the other hand, are established by companies for various strategic or administrative purposes rather than to engage in business operations. A final thing worth mentioning before we dive into some concrete examples is that “tiered structures” are prevalent in which a subsidiary of one entity can be the parent of a third entity—which, in turn, can be the parent of yet another entity. In other words, what determines the parent-subsidiary relationship is not so much about the functions each performs within the operating framework but rather which entity ultimately controls the other. With that out of the way, let’s try to make sense of this with some real-world examples. 

  • Operating subsidiaries. Operating subsidiaries engage in active business operations and are used for a wide variety of purposes which may include, developing and marketing new product lines, expanding into new global markets, or achieving other organizational benefits and efficiencies. An operating subsidiary’s parent may be active or dormant depending on the parent’s level of control and involvement in its operations. 
  • Holding company subsidiaries. Holding company subsidiaries are often intermediary entities used within tiered structures to own and other control shares of other entities on behalf of the parent for asset protection, tax, and risk mitigation purposes. For example, multiple investors may establish and fund a holding company to invest capital in a joint real estate venture. 
  • Shell company subsidiaries. Often used for their tax benefits, shell companies are like holding companies in that they have minimal operations of their own. However, while holding companies are more likely to hold shares and be active to some extent in exerting control and direction over their investments, shell companies are more likely to hold assets and are dormant. For example, a company may form a shell subsidiary to acquire and hold intellectual property (IP) and license out the IP rights to third parties. 
  • Acquisition subsidiaries. Acquisition subsidiaries are temporary single-purpose entities used by parents to acquire another company or its assets. Using an acquisition subsidiary instead of acquiring the target outright can provide the parent with significant risk mitigation and tax advantages.

Parental liability for a subsidiary’s debts and obligations

Because shielding parents from the debts and liabilities of their subsidiaries is among the most beneficial and commonly understood advantages of using a subsidiary in the first place, it is important to point out that there are some very significant exceptions and limitations to those principles. 

While specifics and applicability will differ greatly based on a number of factors such as the form and structure of entities, the laws and regulations that apply to each entity in the respective jurisdictions they operate or maintain assets in, as well as the particulars of the contractual relationships between them, a parent may be liable for:

  • Neglecting their duties and obligations in supervising the subsidiary and exercising control over its operations to the extent required under contractual agreement or by law 
  • Damages caused by defective products caused by the subsidiary’s negligence that the parent was aware of and failed to rectify 
  • Tax obligations of the subsidiary where the parent acted fraudulently for tax evasion purposes 
  • Cleanup costs to rectify environmental damages caused by the subsidiary
  • A subsidiary’s obligations and debts to third parties, such as investors, suppliers, customers, and clients, if the parent made certain representations or guarantees on behalf of the subsidiary or abused it to mislead or defraud them

Bottom Line

As you can see, while the potential advantages of using subsidiaries are immense, there are also many intricacies and complex considerations to take into account. 

Through AAL’s directory, you can find many skilled attorneys with extensive experience in corporation and business law practice who can be an invaluable resource in choosing the best form of subsidiary for you and your business.

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