This paper investigates the effect of internal embeddedness within multinational corporations (MNCs) on overseas subsidiaries’ innovation. We examine the extent to which two types of internal embeddedness -vertical and horizontal- facilitate or inhibit a subsidiary’s exploitative and exploratory innovations respectively. We tested our hypotheses using patent data of 240 overseas subsidiaries of 15 global semiconductor companies from 1989 to 2008. The results suggest that overseas subsidiaries are more likely to generate exploitative innovations when vertical internal embeddedness is high, while they are more likely to generate exploratory innovations when horizontal internal embeddedness is high. We also find that the effects of vertical and horizontal embeddedness on exploratory innovation vary by different levels of subsidiary capability. Specifically, both vertical and horizontal internal embeddedness showed positive impacts on exploratory innovation for more capable subsidiaries, while vertical internal embeddedness showed a negative effect for less capable subsidiaries. These findings imply that MNCs need to adjust the level of vertical and horizontal internal embeddedness to promote subsidiary innovation according to innovation types and subsidiary capabilities.