A Parent-Subsidiary Relationship

A holding company is a corporation that is organized for the purpose of owning stock in other corporations. It is characterized by its control of the voting power of other companies. For the purpose of exercising management control, it should acquire enough voting stock in those companies in order to become their holding company.

Holding companies and the companies they control have a parent-subsidiary relationship. The holding company is called the parent company and the controlled company is the subsidiary. If the parent owns 100% of the voting stock of another company, that company is said to be a wholly-owned subsidiary of the parent company. However, subsidiaries could also own controlling interest in another company, thus becoming its parent company. This structure is called corporate pyramiding.

A pure holding company exists solely for the purpose of owning stock in other companies and does not engage in business operations separate from its subsidiaries. If the holding company engages in its own business operations, then it is said to be a mixed holding company. Meanwhile, conglomerates are holding firms whose subsidiaries engage in unrelated lines of business.

Depending upon circumstances, the parent or holding company offers organizational advantages over other forms of business organization. Its role is to give each subsidiary the administrative autonomy, financial flexibility, and governance structure it needs to compete and develop.

The following are some advantages of establishing a parent-subsidiary corporate structure:

Business Spin-Off

Sizable firms, especially those who are planning to diversify their products and services or entering a new venture, resort to using the parent-subsidiary approach in the management of their business operations. Its mode of formation may result from either the transformation of a pre-existing operating firm or from the creation of a new company (spin-off).

Business spin-off usually occurs when a company with several business lines decides to sell one or more of its segments, or split its business operations by creating a new company to undertake one or more of its business lines. The usual type of spin-off involves the separation of marketing unit to handle the sales and promotion of core businesses.

Management Control

It is usually possible to obtain control of another company with less investment than would be required in a merger or consolidation because a holding company only needs a controlling interest in the acquired company. Owning more than 50% of the voting stock of another company ensures control; however, the International Accounting Standards (IAS) redefines “control”, which is now referred to as the power to govern the financial and operating policies of a company so as to obtain benefits from its activities. Hence, a holding company could still obtain control of another company even though it owns less than 50% of the voting power, provided that it has power over more than half of the voting rights by virtue of an agreement.

Financial Advantage

The existence of the parent-subsidiary structure facilitates the circulation of financial flows between a group of companies in terms of borrowing, credit guarantees, subscription to the capital of a subsidiary company that needs additional equity for expansion and development, cash advances, etc.

A holding company has usually better access to the capital markets, making it easier to secure the funds necessary to conduct large-scale operations or finance an expansion. Moreover, a holding company will be enjoying a substantial borrowing capacity as shares of stocks in the subsidiary company are held as assets on the book and can be used as collateral for additional debt financing.

The establishment of consolidated accounts within the group of companies enables the holding company to assess the situation of each of the subsidiaries in relation to other subsidiaries. Also, the creation of a cash pool will provide more liquidity to the group, in which case, the financial situation of the subsidiaries will then be eased by reducing recourse to banking and financial intermediaries' supports.

On the other hand, tax optimization is a major economic consideration in the formation of a holding company. It is made possible by offsetting profits in one part of the business with losses in another, and thereby, reducing the overall taxable corporate income on the consolidated tax return.

Legal Edge

Holding companies and their subsidiaries are considered separate legal entities. Hence, the assets of the parent firm and the individual subsidiaries are protected against creditors' claims or law suits filed against one of the subsidiaries. Liabilities cannot be passed on to the parent company. As such, the parent firm's assets and credit rating are still protected despite its subsidiary's financial woes.

While establishing a parent-subsidiary structure will clearly help to achieve corporate objectives; however, companies must structure it in such a way that it does not run afoul of tax, labor and other corporate regulations, particularly those relating to inter-company transfers of assets and liabilities. Below are some activities that require good regulatory compliance and cautious implementation:

Special Purpose Entities

Aggressive use of subsidiaries via special purpose entities in an attempt to avoid government taxes and hide high-stakes deals from investors' scrutiny could ran a parent company into serious accounting trouble. Special purpose entities are any type of corporate entity, such as a limited partnership, created for a specific transaction or business that is usually unrelated to a parent firm's main business. They are especially designed to keep debt off the parent firm's balance sheet – a tool for “window dressing”.

The parent firm normally backed its special purpose entities' debts. Once the former arranged to guarantee loans of its special purpose entities, its financial independence and the legal protections that go with it are compromised. A guarantee blows away the liability protection because by contract or agreement the special purpose entities have had somebody else to share in the obligation.

Inter-Company Transfers of Assets and Liabilities

Companies must be careful when booking inter-company transfers to and from subsidiaries. There is this classic example that a parent company classified its transfers as loans. But since it was not charging any interest to its subsidiary, the transaction should actually be capital contributions. Such mistakes could lead to an expensive audit, or worse a penalty from the tax bureau.

Consolidated Financial Report

Although, subsidiaries and their parent company are considered separate legal entities; however, there are instances that they may be considered as a single economic entity, in which consolidated financial statements are then prepared for the entire group. In latter case, the required controlling interest must be met to allow a holding firm to file consolidated financial statements; otherwise, they will be taxed separately as would be the case with most wholly-owned or virtually wholly-owned (less than 100% owned) subsidiaries who are also parents to other companies. There is no group relief system for related companies in some jurisdictions.

Another instances would be when a parent firm's control is intended to be temporary because the subsidiary is held with a view to its subsequent disposal in the near future, or when a subsidiary operates under severe long-term restrictions that impairs parent's ability to transfer funds, then a holding firm has to eliminate the subsidiary in full in its consolidation report.

Dividend Declaration

The setting up of a holding company may no longer be a tax efficient structure to park dividends due to the imposition of the 10% improperly accumulated income tax on unreasonable retained earnings. Dividends may only be declared out of the firm's unrestricted retained earnings. Hence, equity in net earnings in subsidiaries may not be declared as dividends unless received as dividends.

In order to avail of a tax exemption, retention due to reasonable business needs must be proven first. Meanwhile, profit retention in a holding company is a prima facie evidence of unreasonable profit retention.

In summary, therefore, maximizing subsidiary profitability is not the major motivation behind the holding firm's decision regarding equity control and management of subsidiaries. Rather, the decision to put up a parent-subsidiary corporate structure is more strategic in nature like attaining economic viability status, gaining tax advantages, controlling deployment of intangible assets, risk management, corporate accommodation, among others.

**Paper submitted by Ludwig Ritchel A. Kalambacal to Duraville Marketing Inc.

*See related blogs:

http://kalambacal.blogspot.com/2007/09/advantages-of-having-multiple-marketing.html