TheStreet

What Is a Subsidiary?

A subsidiary is a company whose stock is owned either entirely or in majority part by another company. While the subsidiary operates independently and is a separate entity, the parent company ultimately controls the subsidiary's decisions by appointing its leadership. A few key terms:

• Parent company, or holding company: The company which owns the subsidiary.

• Subsidiary: A subsidiary in which the parent company owns more than 50% but less than 100% of the firm's stock.

• Wholly owned subsidiary: A subsidiary in which the parent company owns 100% of the firm's stock.

• Affiliate: A company which has a minority share of its stock controlled by another firm. While this gives the parent company voting privileges in the affiliate, it does not confer the kind of control that comes with subsidiary status.

How a Subsidiary Works

A subsidiary is formed in three common ways:

• The parent company purchases more than 50% of an existing company's shares, acquiring it and making it a subsidiary firm; or

• The parent company purchases more than 50% of the shares of another firm's parent company, acquiring both in the process; or

• The parent company uses its own assets to launch a new, independent firm. In this case it can either retain the new company as a wholly owned subsidiary or it can sell some of the new subsidiary's stock.

It is also possible, but less common, for a company to create a parent company which it then becomes a subsidiary of. This was the case recently with Google, which created the company Alphabet (GOOG - Get Report) and made Google a subsidiary of that new firm.

A subsidiary operates independently of the parent company and is a separate legal entity. They do not have to be in related industries. It is, in fact, common for companies to own other firms which operate in entirely unrelated fields as a way of diversifying their operations.

The parent company exercises control over the subsidiary due to its ownership of the other firm's stock, which allows it to appoint members to the board of directors. By owning more than half of the subsidiary's stock the parent company has the right to appoint more than half of its board members. Not only does this allow the parent company to decide the subsidiary's leadership, and through this leadership the subsidiary's policies, but it is also extremely common for individuals to sit on the board of directors for both a parent company and its subsidiary.

Subsidiaries are not under the direct control of a parent company. While this is often a distinction without a difference, officers of the parent company cannot directly pass or implement policy in the subsidiary firm. They can only appoint and direct members of the subsidiary's leadership.

A subsidiary can itself own other subsidiaries. This is increasingly common and has led to modern corporations that are several layers deep.

Subsidiaries owned by the same parent company are called "sister companies." Sister companies operate independently, even sometimes in direct competition with each other. They often have absolutely no relationship beyond having the same parent and seeing each other at the annual Christmas party, much like sisters in real life.

How Profits From a Subsidiary Are Collected

A parent firm collects profits from its subsidiaries through dividends and shareholder payments. The subsidiary's board of directors will pay its profits to shareholders, which in this case will mean (at least in majority) the parent company. Through its control of the board of directors, the parent company can determine how much or little of the subsidiary's profits it wants to funnel into the parent company through shareholder payments.

It is important to note, however, that unless a company is a wholly owned subsidiary the parent company cannot collect all of its profits. When a subsidiary distributes profits to its ownership, the parent company will only collect based on its share of ownership.

Most firms report all of the profits from their core operations and subsidiaries in one statement. This practice is called consolidation.

Subsidiary vs. Division

It is critical to distinguish a subsidiary from a division.

The latter is not a separate legal entity. While it may have its own name and operate publicly as though it were independent, a division is still a direct part of the company which owns it. It shares none of the features or protections of a subsidiary; its debts, liabilities and profits all accrue directly to the owning company; and the owning company exercises direct control over it.

Example of a Subsidiary

Almost every major, modern company operates on a subsidiary structure, either as a parent company, a subsidiary or both.

The food industry is a particularly good example of this. PepsiCo (PEP - Get Report) is known for producing Pepsi. It also owns a wide variety of other companies which produce drinks and snacks, such Quaker Oats, Tropicana and Naked Juice, (to name just a very few.)

These three firms are sister companies. They all operate independently of each other but are all owned by the same parent company, even though Tropicana and Naked Juice are in direct competition.

Through this structure PepsiCo also owns Gatorade as a subsidiary company. Quaker Oats purchased Gatorade when it was an independent firm. Once PepsiCo acquired Quaker Oats it also acquired Gatorade as a downstream subsidiary.

Four Advantages of a Subsidiary

There are four key advantages to operating a subsidiary.

1. Tax Liabilities

A subsidiary firm pays its own taxes. Furthermore, the respective losses and gains from subsidiary firms can allow a parent firm to structure its taxes to take advantage of significant tax deductions without actually losing money from its direct operations.

2. Separate Accounting

A subsidiary pays its own debts and expenses, which do not transfer directly to the parent company. As a result, a company can own or spin off a subsidiary in a potentially risky business venture knowing that the parent company's assets are protected from any potential losses. Should an experimental line of business fail, even up to and including bankruptcy, the entire operation can be wound up without risking the core business.

3. Legal Liability

As an independent entity a subsidiary is responsible for its own legal liabilities as well as its debts and taxes. This means that lawsuits against the subsidiary cannot collect against the parent company's assets, only those of the subsidiary.

4. Efficiency and Diversification

Subsidiaries allow a company to spin off operations into smaller, more efficient companies. This is particularly useful for companies that want to diversify into new, unrelated fields.

A single firm trying to operate in multiple, unrelated industries can often run into operational difficulties and higher expenses. The subsidiary structure allows a parent company to work in several different fields at once, while allowing each organization to focus on core competencies.

Piercing the Corporate Veil

Finally, it is important to note that these protections are not absolute.

In the cases of debt, lawsuits or other liabilities, courts may pass liabilities up to the parent company if they find that the parent company and subsidiary essentially operated as a single firm. This is called piercing the corporate veil, and it is a process designed to prevent a company from spinning off subsidiaries as a way of simply insulating itself from its debts.