What Makes a Company a Subsidiary
Whether a company is a subsidiary comes down to control, not exclusively to the proportion of shares held. IFRS 10 defines a subsidiary as an entity controlled by another entity, and an investor controls an investee if, and only if, it has all three of the following:
- Power over the investee — existing rights that give it the current ability to direct the relevant activities.
- Exposure, or rights, to variable returns from its involvement with the investee.
- The ability to use its power to affect the amount of its returns.
A majority shareholding is the most common route to power, which is why ownership percentage is often used as shorthand. The shorthand fails in both directions: an investor with 58% of the shares may not control, and an investor with 46%, or with no shares at all, may. The assessment is made on the substance of the rights each party holds, and is repeated when any of the three elements changes.
Why the answer matters
If the investee is a subsidiary, it is consolidated line by line, with goodwill and non-controlling interests recognised, including in the consolidated statement of cash flows. A foreign subsidiary is first translated, as set out in consolidating foreign operations. If not, it is typically an associate, a joint arrangement or a financial asset, each accounted for very differently.
Power Over the Relevant Activities
Power is assessed in a fixed sequence:
- Identify the relevant activities — the activities that significantly affect the investee's returns. For a manufacturer these are typically purchasing, pricing, production, funding and capital expenditure decisions.
- Identify who directs them — usually the board of directors, sometimes a manager under a contract or a committee established by agreement.
- Identify who decides who directs them — where the board directs the relevant activities and directors are appointed by an ordinary resolution, the party that controls a majority of votes cast at shareholder meetings has power.
Power arises from rights. Voting rights are the usual source, but rights to appoint or remove key management personnel, decision-making rights under a management contract and the purpose and design of the investee can all confer power. An investor with the majority of voting rights has power unless the rights are not substantive, they do not provide the current ability to direct the relevant activities, or another party that is not the investor's agent has existing rights to direct those activities — for example a government-appointed administrator or a manager under a binding contract.
Substantive and Protective Rights
Only substantive rights, held by the investor and by others, are considered in assessing power.
| Substantive rights | Protective rights |
|---|---|
| The holder has the practical ability to exercise them | Designed to protect the interests of the holder |
| No legal, financial or operational barriers prevent exercise | Do not give the holder power over the investee |
| Agreement from other parties is not required, or those parties can be expected to agree | Relate to fundamental changes in the investee's activities |
| Exercisable when decisions about the relevant activities need to be made | Apply only in exceptional circumstances |
Common protective rights include a lender's right to restrict borrowing, a franchisor's rights to protect its brand, and the requirement for a 75% special resolution to amend the memorandum of incorporation or dispose of substantially all the assets. The ability of minority shareholders to block a special resolution does not prevent a majority holder from having power, and does not give those minority shareholders power.
Potential Voting Rights
Options, convertible instruments and forward contracts to acquire shares are potential voting rights. They are included in the assessment only when they are substantive, which depends on:
- Price — an option with an exercise price well above the market price is unlikely to be exercised unless it brings other benefits, such as synergies.
- Financing — whether the holder can obtain the funds needed to exercise.
- Timing — the right must be exercisable when decisions about the relevant activities need to be made. A conversion right that only becomes exercisable after the next shareholder meeting is not substantive at the reporting date.
- Purpose and design — of the instrument and of the holder's other involvement with the investee.
Potential voting rights cut both ways. A substantive option held by the investor can give it power before it holds a majority, and a substantive option held by another party over the investor's own shares can remove power the investor would otherwise have.
Control Without a Majority of Votes
An investor with less than half of the voting rights can still have power through:
- Arrangements with other vote holders that give it the right to direct how they vote.
- Rights from other contractual arrangements, for example the right to direct manufacturing processes or financing decisions.
- Potential voting rights that are substantive.
- The size of its voting rights relative to the size and dispersion of other holdings — often called de facto control.
For de facto control, the investor considers the number of other holders needed to outvote it and the pattern of voting at previous shareholder meetings. If attendance has historically not exceeded 88% of the votes, 44% plus one vote carries every ordinary resolution. Where the remaining shares are widely held and no other holder is significant, a large minority holding can give the practical ability to direct the relevant activities unilaterally.
Where the rights are not conclusive on their own, IFRS 10 directs attention to further evidence:
- The practical ability to appoint key management personnel, dominate board nominations, or direct or veto significant transactions.
- Special relationships: key management personnel who are current or former employees of the investor, operations dependent on the investor for funding, guarantees, technology or trademarks, or activities conducted largely on the investor's behalf.
- Exposure to returns that is disproportionately greater than the investor's voting rights.
The same reasoning extends to entities in which the investor holds no equity. An entity that depends on one investor for all of its funding, operates under guidelines set by that investor and delivers all of its output to that investor may be controlled by it through contractual rights and the purpose and design of the entity.
Variable Returns and the Link to Power
Returns are variable when they have the potential to vary with the investee's performance. They may be positive, negative or both, and are assessed on the substance of the arrangement rather than its legal form.
| Returns available to other interest holders | Returns not available to other interest holders |
|---|---|
| Dividends and interest | Economies of scale and cost savings |
| Changes in the value of the investment | Sourcing of scarce products |
| Fees for servicing assets or liabilities | Access to proprietary knowledge |
| Exposure to losses from credit or liquidity support | Limiting some operations to enhance the value of the investor's other assets |
Only one investor can control an investee, but several parties can share in its returns — a non-controlling shareholder receives dividends without having power.
The third element links the first two: the investor must be able to use its power to affect its own returns. An investor with decision-making rights must therefore determine whether it acts as principal or agent. A fund manager exercising rights delegated by investors is an agent and does not control the fund, even though it directs the fund's activities.
Practical Examples
Example 1: A majority holding that does not guarantee control
Harbour Ltd owns 58% of the ordinary shares of Roastery Ltd, a coffee roaster. Directors are appointed by ordinary resolution and decide which green beans to buy, at what cost, and the selling price of the roasted product. A minority shareholder holds a call option to acquire all of Harbour Ltd's shares at 40 per share, exercisable at any time. Roastery Ltd's shares currently trade at 24, and the option holder recently entered business rescue.
- Relevant activities: purchasing and pricing decisions, directed by the board.
- Power: Harbour Ltd's 58% allows it to appoint the board, unless the option is substantive.
- Option: it is deeply out of the money and the holder is unlikely to be able to fund the exercise, so it is not substantive and is ignored.
- Returns and link: Harbour Ltd receives dividends and can influence the decisions that drive them.
Harbour Ltd controls Roastery Ltd. Had the option been in the money and the holder able to pay, it could have been substantive — and Harbour Ltd's 58% would then not have given it power.
Example 2: De facto control with 46%
Meridian Ltd increases its holding in Crest Ltd, a listed retailer, from 38% to 46%. Another institutional investor holds 9% and the remainder is held by shareholders with less than 1% each. Over the past five years, between 86% and 90% of the votes have been represented at annual general meetings. The institutional investor also holds preference shares that convert into ordinary shares only after the next annual general meeting, and that vote only on matters affecting their own rights.
- Power: with attendance of at most 90%, a majority requires more than 45% of the total votes. Meridian Ltd's 46% has carried every ordinary resolution on the historical pattern, and no other holder comes close.
- Special resolutions: other shareholders can block 75% resolutions, but those rights are protective.
- Preference shares: not convertible before the next meeting, so not substantive at the reporting date, and their voting rights are protective.
- Returns and link: Meridian Ltd receives dividends and, through the board, influences the decisions that drive profit.
Crest Ltd becomes a subsidiary on the date of the additional acquisition. Once consolidated, its leases enter the group statements — covered in leases in a business combination — and any balances with the rest of the group are eliminated, as described in intercompany leases under IFRS 16.
Quick Reference Summary
| Question | Answer |
|---|---|
| What is the test for a subsidiary? | Control: power, exposure to variable returns, and the ability to use power to affect those returns. All three are required. |
| Does more than 50% always mean control? | No. Not where the votes are not substantive, another party directs the relevant activities, or another party holds substantive potential voting rights. |
| Can less than 50% mean control? | Yes, through agreements with other vote holders, contractual rights, substantive potential voting rights or de facto control. |
| Which rights count? | Only substantive rights, held by the investor and by others. Protective rights are ignored. |
| When is an option substantive? | When the holder has the practical ability to exercise it before the relevant decisions are made, considering price, financing and timing. |
| Can an entity be controlled without any shareholding? | Yes, through contractual rights and the purpose and design of the entity, together with exposure to its returns. |
| Can more than one party control an investee? | No. Where decisions require unanimous consent of several parties, the arrangement is assessed for joint control under IFRS 11. |
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Conclusion
Determining whether a company is a subsidiary starts with the relevant activities and the rights to direct them, not with the share register. A majority of voting rights is strong evidence of power, but it is displaced by substantive rights held by others, and a minority holding can confer power where other holdings are dispersed, where contracts grant decision-making rights or where substantive options exist.
Because the conclusion decides between consolidation, equity accounting and financial asset measurement, it should be documented against each of the three elements and revisited whenever the underlying rights change.
For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.