A Non-Controlling Interest (“NCI”) in an acquisition raises some interesting issues management must address  expeditiously and precisely.  Lack of attention to details in such a situation could cause insurmountable issues later on.  The NCI shareholders continue to have legal rights, and the controlling interest will ignore these rights at its own peril.  The  new parent corporation (the “parent” or the “acquirer”) should operate the subsidiary ( also known as the “acquiree”) at an “arms-length basis” in order to preserve the rights of the NCI and prevent unpleasant legal surprises down the road. It is not uncommon for a NCI to use the legal system to enforce its rights.   

NCIs arise for a variety of reasons. The common thread in all of these situations is the acquiring corporation does not need to own 100% of the acquiree’s equity in order to accomplish its goals. One common reason is the acquiring company simply does not have enough cash or does not want to dilute ownership  by issuing large amounts of common stock to acquire all of the outstanding common stock of the acquiree. This is particularly true where an acquirer wishes to do multiple acquisitions.  A  NCI  may be used as an incentive for management of the acquiree. As the business grows, the equity in the subsidiary also grows, increasing the value of the NCI.    Sometimes a parent  could simply stumble into a controlling interest by doing a step acquisition. In these situations a corporation may have  accumulated a major stake in a company over time and then finally acquires a controlling stake when a block of stock becomes available.   Foreign governments may also require some local ownership in  its domestic corporations.  Finally, some shareholders may not want to sell, hoping for a better deal in the future.

No matter how the NCI comes about, management needs to keep its eye on not only the financial accounting requirements for consolidation, but the federal income tax requirements for consolidation as well.  A rule of thumb (and it is no more than that) is a parent must consolidate a subsidiary  for financial accounting purposes if the parent owns more than 50% of the voting stock of the subsidiary.  The 50.1% ownership obviously is enough to cement complete control of the acquiree as the NCI can no longer elect directors. 

 Consolidation for federal income tax returns requires ownership of 80% of the subsidiary common  stock and 80% of the value of the acquired corporation. This includes both the common and preferred stock of the new subsidiary.  The 80.1% requirement explains why  corporate transactions are often predicated on obtaining this level of ownership. A consolidated federal income tax return is a major advantage is  the parent has a net operating loss or other tax attributes it can use to reduce consolidated taxes. The consolidation of a profitable subsidiary will shield at least a portion of the subsidiary’s taxable income.

Cash transfers between the parent and the subsidiary can become more complex if there is a NCI. For instance, a parent company owning 100% of a subsidiary can simply declare a dividend if it wishes to transfer cash from the subsidiary to the parent. When there is a NCI, minority shareholders will then receive their  pro-rata share of the subsidiary’s dividends. This may be problematic for the parent if it needs to retain the cash flow of the subsidiary for funding its own operations and that of other subsidiaries. 

The transfer of cash to the parent can be accomplished by other means when a NCI exists.  A management fee is often charged  by the parent to cover the cost of subsidiary functions now assumed  by the parent. The consolidation of support services resulting in economies of scale are a common feature of many acquisitions. For instance, a subsidiary may have previously needed its own accounting department when it was a stand-alone entity. After the acquisition, the parent may take over the accounting function for the subsidiary and charge for these services.  

A tax-sharing agreement can be thought of as putting the parent company “in the place of the IRS”.  In these situations, the subsidiary must make tax payments to the parent in lieu of the IRS.   The subsidiary will calculate its taxes as if were a stand-alone entity and make the required tax payments to the parent company.  This ensures the subsidiary pays its fair share of income taxes or “reimburses” the parent for the use of the parent’s net operating losses or other tax attributes.  

A third way a parent company may transfer cash from its subsidiary is to charge an acceptable profit on down-stream sales.   This occurs when the subsidiary uses the inventory it purchases from the parent in its own production process. The parent will tack on a profit margin to the inventory it sells to the subsidiary.    The profit margin will need to be reasonable, as both the NCI and the taxing authorities will be interested in how income is shifted between the entities. 

The subsidiary should also be operated  as any other corporation.  There needs to be a board of directors with regular meetings and minutes.   If the subsidiary is still publicly traded, the parent must circulate a proxy for the annual meeting or an information statement stating it has sufficient votes to elect directors.   Attention to detail and legal requirements will allow for smoother operations and less potential for legal battles when a NCI exists.