A subsidiary is a legal entity controlled by another legal entity. Subsidiaries are often used to facilitate international trade, but also to obtain legal protection and to better control the profitability of a business.
Whether its to comply with the regulations of a foreign country or to isolate the risks of a real estate investment, various reasons can drive a company’s management to set up a subsidiary.
BDC’s Louis-David Julien, Vice President, Portfolio Management, Growth & Transition Capital, and Pierre Marquis, Senior Counsel, both from BDC, explain the subtleties of the subsidiary.
What is a subsidiary?
“A subsidiary is a company that is more than 50% owned and controlled by another company,” says Julien.
“In the legal sense, a subsidiary is a legal entity, meaning that it has rights similar to those of a natural person,” explains Marquis. “For example, it has the right to own property, buy and sell goods, and take legal action against another legal entity or natural person.”
The company that owns the subsidiary may be a holding company, which is a company whose sole purpose is to own one or more companies. However, the company that owns the subsidiary may also be a parent company that has its own business activities.
Generally, it is preferable for a foreign company that wants to do business in a given territory to create a local subsidiary.
What are the advantages of a subsidiary?
There are several reasons why you may want to create a subsidiary. First, a subsidiary can make your life easier if you decide to do business in another province or country.
“Generally, it is preferable for a foreign company that wants to do business in a given territory to create a local subsidiary,” says Julien. “It’s also easier to manage that company separately from the others as it has to comply with different regulations, including taxes. Then, if the venture doesn’t work out in that country, it’s easy to just close the foreign subsidiary and call it a day.”
Creating a subsidiary is therefore also a way to obtain legal protection both abroad and locally. “When you create a subsidiary, you isolate that company from the others. So if it has a problem, it won’t contaminate the other companies in the group,” he says.
Lastly, a subsidiary is a way to separate different activities so as to better control profitability. “For example, let’s say you have activities in plastics, metal and transportation. It would be better to create separate legal identities to have a clearer perspective of the performance of each business line’s performance,” he says.
Julien adds that if you want to sell the metal-related portion of your business, separate entities will make it much easier to know that business’s profitability, and the assets needed to run it, and to determine its value.
Is the parent company legally responsible for the subsidiary?
Only if it has signed a contractual commitment to be legally responsible. “These are two incorporated companies, therefore two distinct legal entities, and they are legally independent,” says Marquis. “This is one of the main reasons why you would want to create a subsidiary. It enables you to isolate risk. So if a company being sued goes bankrupt, as a rule, you can’t sue its shareholders instead. This is because a company’s acts are binding only on itself. The company’s debts are its own.”
However, this protection has its limits in certain cases of fraud or rights abuse. “Under provincial and federal law, if fraud is proven, shareholders may be held personally liable for damages caused by the subsidiary,” says Marquis. This is what the courts call piercing the corporate veil.
It enables you to isolate risk. So if a company being sued goes bankrupt, as a rule, you cannot sue its shareholders instead. This is because a company’s acts are binding only on itself. The company’s debts are its own.
Why create a subsidiary to carry out a real estate transaction?
It’s common practice to create a subsidiary when a company wants to carry out a real estate transaction. Let’s take the example of a door and window manufacturing company that buys a commercial building for its production.
“The company doesn’t want to mix its main activities in doors and windows with its real estate investments,” says Marquis. “Creating a subsidiary is a way to isolate risk. The new company will be used only to own the building and lease space to the operating company. It could also lease space to other businesses. Creating a real estate subsidiary also allows you to deduct and amortize certain expenses differently.”
Setting up a real estate subsidiary can also boost other transactions. Often, when an operating company wants to obtain a loan, the financial institution will look to the real estate subsidiary for collateral.
“Even though the two subsidiaries are not legally responsible for each other, the bank can tie them together in the loan agreement,” says Julien. “This way, if the operating company goes bankrupt, the financial institution will be able to seize the property. This reduces the risk for lenders.”
What’s the difference between a holding company and a subsidiary?
A holding company is an incorporated company created to hold one or more businesses. “That’s its purpose. It has no other activities,” says Julien. “The companies held by the holding company, that is, the subsidiaries, are operating companies.”
However, a holding company is not the only entity that can own a subsidiary. “An operating company, that is, a parent company, can also have its own operations and hold subsidiaries,” says Marquis.
How do you create a subsidiary?
To create a subsidiary, a company must be incorporated under a law of its choice. “It’s just like incorporating any company, except that its shares must be more than 50% owned by another company, so it can be held as a subsidiary,” says Marquis.
Does a subsidiary require a shareholders’ agreement?
Not necessarily. “As with any corporation, this option will be for the shareholders to choose. It’s up to them to agree amongst themselves on whether to implement such an agreement," says Marquis. “But typically, when there are several shareholders, it’s preferable to draft such an agreement to specify how the shareholders will exercise their rights with respect to the shares they hold. This covers situations where shareholders want to sell, where there is fraud, death, and so on. The more complex the business, the more complex the shareholders’ agreement will be. Businesses that raise funds from investors, especially institutional investors, will typically have such agreements set up.”
To make sure that creating a subsidiary is the best solution for your needs and to do it right, don’t hesitate to seek expert advice.