In business, it is a common strategy for a company to set up a subsidiary. The reasons for this vary, but frequently include risk mitigation, tax optimization, navigating regulatory frameworks and isolating specific business operations.
One of the main legal principles supporting this approach is the concept of separate legal personality, which is a fundamental element of corporate law in many jurisdictions, including in Canada. According to Canadian corporate law, this principle establishes that a corporation is an independent entity, distinct from its shareholders, directors, and officers. As a result, each subsidiary operates autonomously, maintaining its own assets, liabilities, and management, while in theory, if not in practice, still benefiting from the support and strategic direction of its parent company.
However, this legal separation is not absolute. In situations where a subsidiary faces litigation, bankruptcy, or regulatory scrutiny, courts and claimants may seek to extend liability to the parent company. This challenges the presumption of independent legal personality and raises questions about the limits of corporate liability.
When a court does determine that a parent company should be liable for the acts of its subsidiary, this is known as "lifting the corporate veil" or "piercing the corporate veil."
The decision to lift or pierce the corporate veil is not taken lightly by Canadian courts. It is an exceptional remedy, invoked only when the integrity of the corporate structure is compromised or abused.
Typically, Canadian courts will only lift or pierce the corporate veil if the following two conditions are met:
- It is proven that the subsidiary lacks autonomy and functions solely as the "alter ego" of the parent company; and
- It is proven that the corporate structure has been manipulated to facilitate fraud, evade public order, or avoid legal obligations.
Lifting or piercing the corporate veil remains an exception as legal remedy, generally applied in cases to:
- Prevent or stop fraud and abuse: When a subsidiary is used as a mere façade to conceal any misconduct.
- Discourage evasion of legal obligations: If a subsidiary is created to circumvent tax, contractual, or regulatory duties.
- Recognize excessive control by the parent company: When a parent company exercises such dominant control over a subsidiary that the latter lacks real autonomy.
The purpose of this article is not to explain when these conditions have been met, but rather to outline what practical factors a court will typically consider as part of its analysis as to whether the corporate veil should be lifted or pierced. These factors are as follows:
- Overlap in ownership and personnel: Is there significant overlap in the ownership, directors, or officers of the parent company and the subsidiary? Does the parent hold, directly or indirectly, all or nearly all of the shares in the subsidiary? Were the individuals managing the subsidiary appointed by the parent company?
- Conduct of substantially the same business: Do the parent company and the subsidiary conduct substantially the same business operations or services?
- Undercapitalization of the subsidiary: Does the subsidiary lacks sufficient share capital or long-term financing relative to the scope of its business or debt obligations? Does the subsidiary rely heavily on intercompany loans?
- Single entity or not: Does the parent company present itself and its subsidiary as a single entity, for example by using the same branding, office space and communication channels, such that third parties may reasonably assume they are dealing with one unified business?
- Apparent authority: Does the parent company create the impression that the subsidiary has the authority to act on its behalf? Are shared executives or representatives acting interchangeably between the two entities?
- Independent business discretion: Does the subsidiary exercise its own independent business judgment, or does the parent company control its decision-making processes? Are key decisions made by the directors or officers of the subsidiary or are their powers revoked? Are the decision makers acting primarily on behalf of the parent company, rather than exercising independent judgment in the interests of the subsidiary?
- Maintenance of separate books and records: Does the subsidiary maintain its own financial records and corporate documentation independently from the parent company? Does the subsidiary hold formal, documented, board meetings?
- Financial commingling and financial integration: Has there been any commingling of funds or assets between the parent company and the subsidiary? Are the subsidiary's profits treated as the parent company's own profits? Are all of the subsidiary's profits routinely distributed as dividends ?
- Shared resources: Do the parent company and subsidiary share common office space, addresses, telephone numbers, or other properties?
- Shared business documents: Do the parent company and its subsidiary share business documents such as contracts and invoices or operate using the same representatives?
- Acquisition of equipment and employees: Has the parent company acquired certain equipment or cover employee compensation for the subsidiary?
What key considerations should guide the structuring and operation of a subsidiary to help preserve its legal independence and reduce the risk of parent company liability?
A. The most important is that merely incorporating a subsidiary is not in and of itself sufficient to ensure legal separation from the parent company or shield the parent company from liability for the actions of its subsidiary.
B. It is not required that all of the above factors be present for the corporate veil to be lifted or pierced.
C. The more these factors are present in a particular situation, the greater the likelihood that the corporate veil will be lifted or pierced.
D. The following practices help to reinforce the separation between the two entities:
- Maintain separate legal structures: ensure the subsidiary is properly incorporated with its own share capital, bylaws, and corporate structure. Appoint independent directors and officers, even if affiliated with the parent.
- Follow corporate formalities: Maintain separate financial records, board minutes, and filings.
- Ensure financial independence: Use separate bank accounts and accounting systems.
- Distinguish branding and communication: Use unique names, logos, emails, and websites. Ensure that third parties clearly know who they are dealing with in their contracts and invoices.
- Balance control with autonomy: Use formal agreements (i.e. shareholder agreements or reporting arrangements) to oversee the subsidiary, but avoid informal directives or day-to-day interference from the parent company that undermines the subsidiary's autonomy and discretion.
- Document intercompany dealings: Where possible, structure and document intercompany transactions to reflect commercially reasonable terms. Even if full market parity isn't practical, maintain written agreements and clear rationale to support the arrangement.
- Do not mislead third parties: All representations made to creditors, suppliers, or business partners must be accurate and made in good faith.
Thinking about how your subsidiary fits into your broader corporate structure? Whether you're aiming to keep operations fully separate or exploring other strategies, it's important to understand the risks.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
