Find out more about what makes a subsidiary, how it works, pros and cons, and what it can mean for individual investors.
Definition and Example of a Subsidiary
A subsidiary can be created when a company purchases another company—or at least becomes the majority shareholder. Subsidiaries also can be started by a parent company. In the parent-subsidiary relationship, the parent company owns a controlling share of the subsidiary’s stock or capital, so it is able to control the subsidiary’s activities, such as business strategy and appointing a board of directors and executive leadership. One of the most prominent examples of a holding company is Berkshire Hathaway, the multinational conglomerate chaired by CEO Warren Buffett. Companies that are wholly owned by Berkshire Hathaway include GEICO, Fruit of the Loom, and Dairy Queen. Buffett’s company also holds non-controlling shares of numerous companies, including Apple, Coca-Cola Co., Bank of America, and Kraft Heinz Co. Another well-known holding company is Alphabet, the parent company of Google. The company originally incorporated under the name Google, but changed the name of the parent company to Alphabet in 2015. Alphabet has started some of its own subsidiary companies, such as self-driving technology developer Waymo, and purchased other companies that it now wholly owns, including YouTube.
How a Subsidiary Works
It is important to note that holding a subsidiary is different from a merger transaction. In a merger, an acquiring company absorbs the assets of another company and the acquired company ceases to exist as a separate entity. A merger requires approval of the acquired company’s stakeholders; purchasing a controlling share of a company does not. A company can also acquire a controlling share of another company and make it a subsidiary with less capital than it may take to merge with another company. Or it can undertake a “short-form merger” with a subsidiary in which it has at least 90% ownership and take the unit over completely, often without the need for shareholder approval. A subsidiary may operate in a completely different industry than the parent company. Also, subsidiaries often operate as distinct legal entities from the parent company. For example, Dairy Queen and GEICO, two wholly owned subsidiaries of Berkshire Hathaway, serve completely different consumer needs. In other cases, the products or services of a subsidiary may be closely related to its parent company. Google and YouTube, both wholly owned subsidiaries of Alphabet, are internet platforms that derive the majority of their revenues from advertising.
Accounting and Taxes With Subsidiaries
Corporations can file consolidated federal tax returns for multiple affiliated companies that consist of a parent and subsidiaries that are directly or indirectly owned at at least the 80% level. One reason this may be done is to offset the net loss of one company against the net profit of another company in the group. Many companies establish subsidiaries in other countries, sometimes because the country where a subsidiary is being established requires this. It is also common for large U.S. companies to establish subsidiaries overseas to take advantage of a country’s lower tax rate. Soon after being elected, President Joe Biden announced desire to implement an offshore tax penalty for companies that produce goods and services offshore but sell them in the U.S.
Pros and Cons of a Subsidiary
Pros Explained
Limits risks to the parent company: Some subsidiaries are startups or young companies with less-established track records. By structuring them as a separate entity from the parent company, the parent company often is not held liable for debt incurred by a subsidiary that fails. Potential tax advantages: Many subsidiaries operate in foreign countries with lower taxes. Also, when a parent company consolidates its tax reporting, it can offset the profit of one company against the loss of another in the group of companies. Synergy with other group companies: Parent companies with subsidiaries that operate in the same industry can share proprietary information and reap the benefits of joint research and development.
Cons Explained
Can be held liable: Parent companies have been held liable for the debt of or adverse legal rulings against subsidiary companies.Complex accounting and tax reporting: Simply stated, more companies in a group means more assets, debts, and tax requirements.Less independence for subsidiary companies: Executives at a parent company typically have the ability to overrule business decisions made by executives or a board of directors at a subsidiary company.
What It Means for Investors
Before purchasing shares of a publicly listed company, investors would be wise to research whether there are subsidiary companies, and how they are performing financially. Subsidiaries can be beneficial to the overall growth and revenue of a parent company, or they can drag on a parent company’s performance.
