Global expansion FAQ: What is a foreign subsidiary?
Typically, more sales opportunities in foreign markets translate into stronger revenues. Data from a study by OFX Group indicates that 96% of U.S. businesses feel “confident in conducting business overseas.”
The question for companies considering international expansion outside of the U.S. is how to get the job done. And that’s no easy task. The trick is to maximize market dynamics and business opportunities and minimize operational and bureaucratic challenges that threaten profit potential overseas.
One option to evaluate is a foreign subsidiary.
What is a foreign subsidiary?
A foreign subsidiary is a company operating overseas that is part of a larger corporation with headquarters in another country, often known as a parent company or a holding company. Companies primarily open foreign subsidiaries to establish a corporate foothold in a specific overseas economy. This decision may boost revenues, generate tax benefits and diversify company assets to better manage risk.
The designation of a foreign subsidiary depends on how much of the company is owned by the parent company, as follows:
- The parent company usually holds a controlling interest in more than 50% of the foreign subsidiary’s stock.
- In the event that the dominant company owns 100% of the share, that subsidiary is known as a wholly owned subsidiary.
- If the parent company owns less than 50%, the designation changes to an associate or affiliate company.
Structurally, a foreign subsidiary operates independently from its parent company. It is responsible for its own assets and liabilities, and is deemed to be a separate legal entity for taxation and regulatory oversight by the subsidiary where the company is established. In other words, U.S. laws don’t apply. Foreign subsidiaries are governed by the country where the subsidiary operates.
What a parent company can control is the overall makeup of the foreign subsidiary. The parent company can take the following actions:
- Establish a governing board of directors.
- Establish a foreign subsidiary on its own terms, with no need for a shareholder vote.
- Sell a subsidiary without shareholder approval.
Understanding common types of structures
Although sometimes used interchangeably, there is a difference between branches, subsidiaries and permanent establishment. The main distinction between a branch and subsidiary depends on the relationship to the parent company. A foreign branch is an extension of the parent company, but a subsidiary is set up as its own entity. This impacts the taxation, governance and liability of the parent company.
Foreign Branch
The foreign branch operates under the ownership of a parent company, which holds a 100% stake and assumes liability for all branch operations. As an extension of the parent company, the foreign branch is restricted to acquiring talent through contractor hires or employee relocations from the parent company's home country. This necessitates adherence to intricate immigration procedures. Additionally, the foreign branch utilizes the same tax return as its parent company.
Foreign Subsidiary
A foreign subsidiary possesses legal independence from its parent company and manages its distinct business operations. It is obligated to adhere to local taxation and employment laws, which frequently differ from those in its home country. In the event of legal actions or fines imposed by local authorities, the subsidiary bears the responsibility, with the parent company maintaining immunity.
Permanent Establishment
A permanent establishment denotes a business status that imposes diverse taxes on foreign enterprises maintaining a continuous presence in a foreign jurisdiction. This status is applicable to businesses with a stable presence in the host country, acting as a dependent agent of the parent company. The ramifications of permanent establishment differ among jurisdictions, but it commonly instigates a local tax responsibility for the affected business. This may include obligations for income tax, sales tax, value-added tax (VAT), and other local taxes mandated by the host country.
Pros and cons of a foreign subsidiary
Like any other major business endeavor, setting up a foreign entity has its upsides and downsides. These factors are at the top of the list:
Pros of a foreign subsidiary
Major advantages in being a parent company. A company that opens its own foreign branch has considerable clout in how that subsidiary is run. By installing its own board of directors, the parent company can take a “top-down” approach. They can institute their own unique culture, values and vision in the subsidiary.
The subsidiary also benefits, primarily being on the receiving end of valuable shared resources. This includes financial systems, technology systems, sales and marketing experience, and vast business opportunities that stem directly from the parent company. Those resources enable the subsidiary to shift into higher gear immediately, and better compete in its market.
Entry into profitable new markets. As the business adage goes, “if a company isn’t growing, it’s dying.”
The same is true for opening a foreign subsidiary. It allows the parent company to expand into regions and industries it otherwise could not. With new foreign investments come new customers and new sales opportunities that enable the parent to build its brand in potentially profitable foreign markets.
A foreign subsidiary earns more credibility—and protection—overseas. BBy and large, companies that launch a subsidiary overseas tend to be taken more seriously by local industries, governments and business affiliates than companies that opt to simply create a branch office in a foreign country.
For example, foreign financial institutions are more open to doing business with a foreign subsidiary. This has the legal and fiscal stamp or approval of the local and country government where the subsidiary is located.
Plus, a parent company has limited liability for its foreign subsidiary.
For instance, if a foreign subsidiary is entangled in litigation issues, the liability lies with that subsidiary and not the parent or holding company. This ensures protection from any substantial financial penalties that may result from legal issues overseas. Additionally, if a subsidiary proves to not meet expectations (or worse) the parent company can easily sell the subsidiary, often to a company in the same foreign country.
Cons of a foreign subsidiary
Costs can accumulate. Rolling out a foreign subsidiary can be an expensive proposition—both financially and in time requirements.
While costs vary from country to country, it’s common to see capital requirements of several hundred thousand dollars to set up entities in foreign countries, and timeline requirements that can last six to nine months. Additionally, some country legal mandates require parent companies to send staffers on-site to sign documents and attend certain meetings, adding more costs and time to the bottom line.
Exiting a country where you have established a foreign subsidiary can also be very costly and complex, as statutory filing fees can last months. In China, liquidating a wholly owned foreign subsidiary can take eight to 12 months.
A five-year financial feasibility study is recommended for companies looking to start a foreign subsidiary.
Cultural differences. U.S. companies may find cultural and commercial assimilation in a foreign country to be an uphill climb.
Aside from the language, currency and physical distance issues, operating in a foreign country often means dealing with different bureaucratic, political, exchange rate, and legal issues and processes. And that requires local expertise versed in the nuances of the local requirements to protect the organization from a range of compliance risks.
Staffing acquisition and onboarding issues. Bringing new talent on board overseas creates its own challenges for a parent company’s human resources departments.
With hiring processes and norms varying from country to country, inside knowledge on local job postings, interviewing, job offers, benefits and onboarding is not a luxury—it’s a necessity when operating a foreign subsidiary.
Is a foreign subsidiary a good option for your company?
Whether or not you should establish a foreign subsidiary depends on your company’s own unique long-term business goals and objectives. That process starts with a robust and thorough review of your company’s financial, logistical and management capabilities, and where your best “fit” may be overseas. The operation of your international business often depends on the laws and regulations of the country.
It’s also advisable to run different in-house review scenarios to see if a foreign subsidiary makes better sense than simply opening a branch office overseas. After thorough review, you may find you need to move quickly in order to “test the waters” in your target markets while you evaluate further investment in a foreign subsidiary.
With a GEO, our employer of record service, you can hire employees in-country in as little as two weeks while you plan your local market strategy—or indefinitely, depending on your long-term goals.
The future really is now for companies looking for market access overseas—all you have to do is find the right roadmap to get there.
Learn more about the costs and risks that could apply when creating a foreign entity, so you can decide if it's the right next step for your organization.
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