We have distributed team with client and contractor term in different location. The client has sufficient license for TFS system and they use it for development. We do not have sufficient license to use the TFs so we use the local Subversion and it works fine.
The problem is merging the two source is always painful. Any tips shall be appreciated.
How comes you don don't have licenses? The cost of a TFS license is not that high once the server is in. I storngly suggest apying for the licenses (it is really not a lot given you are contractors). Then put up a local TFS proxy... which will REALLY increase your speed.
No more need for merging and you can start using more than only the source control functionality of TFS. You loose out a lot with the client, in terms of integration.
In principal, there is no problem working this way. I have seen people use SVN remotely and Git locally (a bit tricky, but can be made to work), in a similar fashion.
It appears that you are experiencing the problems of large merges - this would not change if you were all using TFS and only merging once a week/month etc...
You need to merge often, daily if not more often, in order to minimize merge conflicts. Before you merge your code, get latest from the client and fix the issues.