A subsidiary is defined as a company owned or controlled by another entity, known as the parent or holding company. A subsidiary is generally considered a separate legal entity from its parent company for taxation, regulation, and liability purposes. This legal separation is the primary reason businesses utilize the subsidiary structure, as it provides the parent with protection against the subsidiary’s financial obligations and legal claims.
The Core Principle of Separate Legal Entity Status
The separate legal entity status is a fundamental tenet of corporate law, establishing the subsidiary as a distinct “person” capable of acting independently. This corporate personhood means the subsidiary can own assets, incur debts, enter into contracts, and sue or be sued in its own name. Although the parent company maintains control, usually by owning a majority of the subsidiary’s voting shares, this control does not legally merge the two entities.
The separation establishes the principle of limited liability, a primary benefit of the subsidiary structure. Limited liability restricts the parent company’s exposure to the subsidiary’s debts and obligations to the amount of its investment. This protection means the parent company is generally not responsible for the subsidiary’s liabilities, and the subsidiary is shielded from the parent company’s financial distress.
Subsidiary Versus Branch or Division
Businesses choose the subsidiary structure specifically to gain the benefits of separate legal personality, which is not available through organizational forms like a branch or a division. A division is an integrated business unit that is fully a part of the main company, sharing the parent’s legal identity entirely. Similarly, a branch office is merely an extension of the parent company, operating under the direct authority and full legal and financial responsibility of the main corporation.
The subsidiary, conversely, is incorporated as a new entity under local law and maintains its own legal existence. This structural difference means a subsidiary must maintain separate accounts and is taxed as an independent company in its operating jurisdiction. This independent status allows subsidiaries greater flexibility in foreign jurisdictions, where they comply with local regulations as a resident company.
The Critical Exception: Piercing the Corporate Veil
Despite the general rule of separation, the legal barrier between a parent and its subsidiary is not absolute. Courts may disregard this distinction under exceptional circumstances, a process known as “piercing the corporate veil” or applying the “alter ego” doctrine. This holds the parent company liable for the subsidiary’s actions or debts. Courts typically apply this remedy only when the subsidiary is found to be a mere “instrumentality” of the parent, lacking genuine corporate identity, and where upholding the separation would result in fraud or injustice. This analysis requires proof of both improper control and resultant injury.
Failure to Observe Corporate Formalities
Courts examine whether the parent company respected the subsidiary’s separate corporate existence by observing required internal governance procedures. Failing to hold separate board meetings, neglecting to record minutes and resolutions, or not properly electing officers and directors suggests the subsidiary is not truly independent. Ignoring these formalities indicates that the corporate entity is not being treated as a distinct legal person.
Commingling of Assets
The intermingling of financial affairs is a common factor cited by courts when deciding to pierce the veil. This occurs when the parent and subsidiary use the same bank accounts, pay each other’s expenses without proper documentation, or treat the subsidiary’s property as the parent’s own. This lack of financial distinction undermines the premise of the subsidiary’s separate legal existence.
Undercapitalization
A court may pierce the corporate veil if the subsidiary was created without sufficient financial resources to cover the foreseeable risks and debts of its operations. The law expects that an entity must be adequately capitalized to conduct its business without relying on the parent to cover potential liabilities. Creating a subsidiary that is intentionally insolvent or too thinly funded suggests an improper attempt to shield the parent from legitimate business risks.
Fraud or Misrepresentation
The most direct path to piercing the corporate veil is demonstrating that the subsidiary structure was used to facilitate fraud, evade existing legal obligations, or deceive creditors. This involves situations where the parent company manipulates the subsidiary’s structure or assets to prevent a creditor from collecting a debt or to engage in wrongful conduct. A court will look beyond the corporate form when necessary to achieve equity and prevent injustice.
Requirements for Maintaining Legal Separation
Business owners must take continuous steps to ensure the legal separation between the parent and subsidiary remains intact and enforceable. Maintaining distinct financial independence is a foundational requirement, which means establishing and using separate bank accounts and accounting systems for each entity. All material transactions between the parent and subsidiary must be executed at arm’s length, structured with terms and pricing standard between two unrelated parties.
Compliance with corporate formalities is also necessary, including documenting separate board meetings, resolutions, and annual filings for the subsidiary. The subsidiary should have its own management team, or at least formally appointed directors and officers. The parent company must avoid making day-to-day operational decisions that bypass the subsidiary’s leadership. Additionally, avoiding public references to the subsidiary as a mere “division” or “department” helps reinforce its separate identity.