What is a subsidiary (Tochtergesellschaft) and what is its relationship to the parent company (Muttergesellschaft)?
In this article, you’ll learn how a holding company is established and how liability works for subsidiaries in Germany.
Subsidiary company: Definition
A subsidiary (Tochtergesellschaft or Tochterunternehmen) is a company that is dependent on a parent company (Muttergesellschaft). It’s also referred to as an affiliate (Untergesellschaft) or interrelated company (Schachtelgesellschaft). Although no particular legal form is specified for a subsidiary, the GmbH, KG or AG legal forms the most common choices for incorporation. In general, a natural person (like an e.K. – a registered sole trader) or a partnership are not generally regarded as subsidiaries, but there are group structures that also include partnerships or natural persons as subsidiaries. The legal framework for subsidiaries can be found in § 290 para. 1 p. 1 of the German Commercial Code (Handelsgesetzbuch – HGB).
Structure of a subsidiary company
From a legal standpoint, a subsidiary is an independent company that’s still economically dependent. However, a subsidiary cannot exist without a parent to exercise control over it. This is done by means of a controlling agreement (Beherrschungsvertrag). It defines how the legal relationship between the parent company and the subsidiary is structured in concrete terms.
Furthermore, most subsidiaries use a profit transfer agreement (Gewinnabführungsvertrag). With this additional contract, the subsidiary undertakes to transfer its profits to the controlling company. The controlled company operates in the interest of the controlling parent company after concluding a control and profit transfer agreement.
The only exception where control remains with the subsidiary is a joint venture. For this, several companies form a cooperation (sorry, we’re still working on the English version of this article).
Although a ten per cent share of the parent company in the other company already classes it as a subsidiary, subsidiaries are almost always majority owned by the parent company. If the parent company holds 100 per cent of the shares, this is referred to as a wholly-owned subsidiary (hunderprozentigen Tochtergesellschaft). This share distribution is the most common.
A spin-off (Ausgründung) of a subsidiary
When setting up a business, the topic of subsidiaries usually plays a minor role. So generally, a business plan rarely contains any information on the establishment of a subsidiary. This is because most founders don’t really think about the possibility when developing their business plan, or they’re simply aiming to become self-employed to secure their livelihood.
Very few founders plan on forming a large group of parent companies and subsidiaries ahead of time. After a successful start-up, however, it often makes sense for a well-developed and large enterprise to transfer a certain portion of the company to a subsidiary – this process is referred to as spinning off (Ausgründung).
What’s the difference between subsidiary, branch and permanent establishment?
While the subsidiary is economically independent of the parent company, a branch (Niederlassung) cannot be legally classified as independent. This is the decisive factor when differentiating from the subsidiary. Legally, a branch always remains part of the main branch (Hauptniederlassung), even if it acts as an independent company.
Whether entrepreneurs can establish a branch at all depends on the corporate structure of their company: Other branches are only suitable for merchants (Kaufleute) and trading companies (Handelsgesellschaften).
Another term that may be confused with a subsidiary is permanent establishment (Betriebsstätte). A permanent establishment is an opportunity for entrepreneurs who are not registered in the commercial register (Handelsregister) to expand their business. This segment includes small traders and shareholders of a GbR. A permanent establishment is largely dependent on the main company and cannot do business in any way without it.
Definition: What is a parent company?
A parent company is a legally independent entity that exercises controlling influence over at least one dependent entity. Further designations are parent corporation, parent group or top company. The controlling influence of the parent company is mostly based on equity interest (kapitalmäßige Beteiligung).
The parent company can have any legal form, but in corporate law, it’s bound by the AG (stock company), KGaA (limited joint-stock partnership) or GmbH (limited liability company) legal forms. In theory, a partnership is also possible as a parent company if it holds a majority interest in the voting rights of another company.
As a general rule, the parent company manages and the subsidiaries and affiliates of these companies are managed. The influence of the parent company can be either direct or indirect.
The parent company forms a group with one or more subsidiaries and, if necessary, further-branched sub-subsidiaries. Another name for this is a Holding.
The relationship between subsidiaries and parent companies
A controlling relationship exists between the parent company and the subsidiary. Since company law must consider the whole, i.e. all subsidiaries and the parent company, it’s always referred to as a Holding. A holding company describes the big picture and can act in many different ways.
In a nutshell, a subsidiary is legally autonomous but economically dependent on its parent company – however, the practical arrangements for this relationship between the two companies can vary considerably. Each holding company structure can, therefore, be defined individually.
The parent company can itself operate with the subsidiary or limit itself to administrative, coordinating and controlling activities. There are four different variants of the holding company:
- Operative Holding: The parent company itself is active in operations, the subsidiaries are very strongly influenced by the parent company.
- Management Holding: Decision making and controlling are defined by the parent company for all subsidiaries. This means that the parent company determines the strategic management or control of the capital flow within the holding company.
- Organisational Holding: The holding structure serves as the internal organisation, with subsidiaries each being responsible for a different business area.
- Financial Holding: This holding variant only serves for asset management purposes.
- Investment company: The parent company assumes the role of a shareholder, while the subsidiaries are responsible for day-to-day operations.
The transactions of parent companies and subsidiaries are balanced out in the course of consolidation in the consolidated financial statements. This means that receivables and payables between the companies are offset against each other.
What is a fellow company?
A fellow company (Schwestergesellschaft) is a company that has the same parent company as another and is located at the same ‘level’. In addition, fellow subsidiaries are linked by their capital, because both were founded using the capital of the parent company.
Spin-off: Why set up a subsidiary?
In Germany, the most common reason for establishing a subsidiary is saving on taxes on exit. Due to large tax savings, almost all the proceeds from the sale of the subsidiary can flow directly to the parent company. You can read more about the tax advantages for the Holding in this article.
The spin-off also takes place for two different reasons, both of which should be considered under the generic term of affiliation:
- Outsourcing affiliation: Existing activities are outsourced (outsourcing, expanding abroad)
- Coordinated affiliation: Existing capacities are expanded (annexation)
A subsidiary is often formed when the parent wants to expand its business and the new line of business no longer corresponds to its core business and/or the original object of the company. This type of spin-off is referred to as outsourcing.
In larger group structures, individual areas of activity are often separated by the establishment of several subsidiaries. In this way, separate business units receive more transparency with clear responsibilities. Also for expansions abroad, subsidiaries are often formed.
The purchase of a foreign company can also create a Holding. With the acquisition, the new company will be aggregated into an existing group. In this way, your own market power can be increased and you can benefit from synergy effects.
A spin-off as a subsidiary may, however, also be done with the aim of selling all or part of it at a later date. It’s much easier to sell a part of a business if it is an independent legal entity.
Subsidiaries and liability
Although the affiliated parent companies and subsidiaries are considered as a whole in corporate law, this is not necessarily the case with regard to liability. If there are economic problems in the subsidiary, these do not affect the parent company as a whole.
Although the parent company retains control, economic problems such as insolvency remain with the subsidiary. In order to ensure creditor protection, there are extensive mechanisms in the relationship between the parent company and the subsidiary to prevent the shareholders of the parent company from being able to disclaim all responsibility for the liabilities of the subsidiary.
Is the parent company liable for the subsidiary?
Both case law and literature deal with the question of whether and, if so, to what extent the parent company is liable for the subsidiary if the latter is a limited liability company. There’s always the separation principle (Trennungsprinzip), which states that the parent company is not liable for its daughters and vice versa. The limitation of liability (Haftungsbeschränkung) limits the liability claim to the company assets of the company concerned.
Nevertheless, there are various interpretations in corporate law according to which the affiliated companies are considered as a whole. Liability is always a complicated issue for subsidiaries and depends on several factors, such as:
- Legal forms of the individual companies in the holding structure
- Individual contractual agreements that have been made
- Cash flow between companies
- The way the companies behave with each other
In principle, a parent company can survive even if the subsidiary goes bankrupt, but the opposite does not always apply. If the parent company goes bankrupt, the subsidiary often does not survive.
Loss compensation and assumption of losses by the parent company
If a subsidiary suffers losses, claims exist against the parent company. This claim for loss compensation regulates the compensation of losses by the parent company. After the conclusion of a controlling and profit transfer agreement, the controlling company is obliged to compensate the losses of the subsidiary and, after its termination, to guarantee security to its creditors.
The claim for loss compensation is based on section 302 of the German Stock Corporation Act (Aktiengesez – AktG). Any annual loss contribution by the subsidiary must also be offset by the parent company. Claims do not expire until ten years after termination of the control or profit transfer agreement. The key date is the deletion from the Handelsregister.
Advantages and disadvantages of a subsidiary
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