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From AGEWiki

A Subfaction is mostly a display artifice so that a coalition can be seen as several factions acting together instead of having a single faction fighting. A subfaction is not a Faction for the game engine, and doesn't have to be declared in the setup. If you want to "assign" a subfaction to a faction, you only really have to make sure the "real" faction has the FactionTag of the subfaction registered in the NativeTag entry of the faction definition file. Doing so will allow the units which have the 'subfaction' FactionTag to show on the map as if they are allies of the primary faction.

An example to clear issues:

In NCP, 1812 campaign, the French faction has the tag F12. This is the sole and unique faction defined against the Russians. i.e the scenario is a duel between faction F12 and faction RUS. But, in the faction definition file for F12, the NativeTag entry defines many FactionTags, like POL for Polish units. As the tag is defined, any unit which bears the tag 'POL' will display on map as an ally, i.e in Pink (the color for the Polish units), and tooltips will indicate that they are Polish units, and not French units. If this was not done, tooltips would indicate that the Polish units were indeed French units, and they would display in Blue.

To complete the behavior, you'll also want to define regions as owned by the subfaction. i.e if a region is registered as being Polish, then the display will show the Polish flag, and not the French flag, when the French conquers it. SubFactions may also be assigned to Regions on the map using AddSubFacRgn. This results in the display of the SubFaction's "flag" when the region is controlled, rather that the flag of the player faction. Any region may have a SubFaction defined from each Playing Faction in that scenario.

The "Command behavior" of a SubFaction is defined in the Faction files by:

Coop Tag The tags which are deemed to be cooperative, for Command purpose (no CP penalty if no leader of these tags are present).

Native Tag List of nations which are allowed to have their own color for units, can have replacements stockpiled by the mother nation, are of interest to be exchanged as prisoners, etc. Does not means there is a cooperation between the 2 nations, a dual nationality leader or a leader from each SubFaction will still be required to avoid CP penalties. Ex: In BOA, German mercenaries are listed as native of the British.