What is a foreign subsidiary and do you need one?

The global business landscape is constantly evolving, and companies looking to expand their operations abroad must carefully consider their options. One way to establish a presence in a foreign market is by setting up a foreign subsidiary. In this article, we will explore what a foreign subsidiary is, its advantages and disadvantages, and whether or not your business needs one.

What is a Foreign Subsidiary?

A foreign subsidiary is a separate legal entity established by a parent company in a country other than its home country. This subsidiary operates under the laws and regulations of the foreign country and is typically subject to local taxation. Foreign subsidiaries can be formed as limited liability companies, joint ventures, or other types of legal entities, depending on the business requirements and the local legal framework.

Learn more about the pros and cons of establishing a foreign subsidiary here.

What is the Difference Between a Foreign Branch and Foreign Subsidiary?

Foreign branches and foreign subsidiaries are two common ways to expand a business internationally, but they are distinct in terms of their legal and financial structures.

A foreign branch is an extension of the parent company and not a separate legal entity. It operates under the parent company's name and is subject to the parent company's liabilities. The foreign branch's activities are also taxed as part of the parent company's income.

In contrast, a foreign subsidiary is an independent legal entity with its own governance and liability separate from the parent company. This separation offers the parent company limited liability protection, meaning that the parent company is not responsible for the subsidiary's debts or legal obligations. The subsidiary's activities are also taxed separately, often at the local tax rate in the foreign country.

For more information, check out this article on Foreign branch vs. Foreign subsidiary: Which is best for global expansion?

What are the Advantages of Establishing a Foreign Subsidiary?

Establishing a foreign subsidiary can offer numerous advantages to a parent company, allowing it to expand its global presence and capitalize on market opportunities.

Limited Liability Protection:

One of the most significant advantages of establishing a foreign subsidiary is the limited liability protection it offers to the parent company. Since the foreign subsidiary is a separate legal entity, the parent company is not held responsible for the subsidiary's debts, legal obligations, or financial liabilities. This separation safeguards the parent company's assets and reputation in cases of bankruptcy, legal disputes, or financial losses in the subsidiary.

Tax Benefits:

Foreign subsidiaries often enjoy favorable tax treatments or lower tax rates in the host country, which can lead to substantial financial benefits for the parent company. These tax advantages may include tax incentives, exemptions, or credits provided by the host country to attract foreign investment. Furthermore, the separate taxation of the subsidiary allows for more efficient tax planning and management, as the parent company can optimize its global tax structure.

Discover how to tax your digital nomads in this employers’ guide.

Access to Local Markets:

Establishing a foreign subsidiary provides the parent company with direct access to the local market, enhancing its global footprint. This presence enables the parent company to better understand and cater to local consumer preferences, forge relationships with local partners, and improve supply chain efficiency. Additionally, the subsidiary can benefit from existing infrastructure, resources, and business networks in the host country, allowing for a more seamless expansion.

Customization and Localization:

Having a foreign subsidiary allows the parent company to adapt its products or services to the local market, addressing cultural, regulatory, and environmental differences. This customization enables the company to stay competitive by tailoring its offerings to meet local needs, comply with local regulations, and resonate with local consumers. Moreover, the subsidiary can provide valuable insights into local trends, preferences, and potential opportunities, which can contribute to the overall success of the parent company's global strategy.

Talent Acquisition:

A foreign subsidiary can serve as a hub for attracting and retaining local talent, giving the parent company access to a diverse workforce with unique skill sets, knowledge, and cultural understanding. This diversity can drive innovation, improve decision-making, and promote cross-cultural collaboration within the organization. Local employees can also provide insights into local business practices, customs, and regulations, enabling the parent company to navigate the host country's business landscape more effectively.

Discover more on global talent acquisition strategies in this comprehensive guide.

What are the Disadvantages of Establishing a Foreign Subsidiary?

While establishing a foreign subsidiary can offer numerous benefits to a parent company, it also comes with its fair share of challenges and drawbacks. This article will provide an exhaustive examination of the disadvantages of forming a foreign subsidiary, including initial costs, complexity, tax implications, dilution of control, and reputation risk.

Initial Costs:

The process of setting up a foreign subsidiary involves various legal, accounting, and administrative expenses that can be substantial. These costs may include fees for incorporation, business registration, and licensing, as well as expenses related to retaining local legal counsel and tax advisors. Additionally, the parent company may need to invest in infrastructure, facilities, and equipment, as well as cover the costs of recruiting and training local employees. These initial expenses can represent a significant financial commitment for the parent company.

Complexity:

Managing a foreign subsidiary adds a layer of complexity to the parent company's operations. Navigating local laws, regulations, cultural norms, and business practices can be challenging and time-consuming. The parent company must ensure compliance with not only its home country's regulations but also those of the host country. This added complexity can strain the parent company's resources, potentially affecting its ability to focus on core business activities and manage other aspects of its global operations.

Tax Implications:

While foreign subsidiaries may benefit from favorable tax treatments or lower tax rates, there can be negative tax implications as well. These may include double taxation, where the parent company's home country and the subsidiary's host country both tax the subsidiary's income. Additionally, transfer pricing issues and tax reporting requirements can arise, further complicating the tax landscape. The parent company must be diligent in its tax planning and compliance efforts, which can be both time-consuming and costly.

Dilution of Control:

As a separate legal entity, the parent company may have less direct control over the subsidiary's operations, which could lead to challenges in maintaining consistent standards and practices across the organization. This dilution of control can make it more difficult for the parent company to enforce its corporate policies, monitor performance, and ensure alignment with overall business objectives. Furthermore, differences in management styles, corporate culture, and communication between the parent company and the subsidiary can create additional challenges in maintaining control and cohesion.

Reputation Risk:

The actions of a foreign subsidiary can impact the parent company's reputation, especially in cases of legal or ethical misconduct. Since the subsidiary operates under the parent company's brand, any negative publicity, regulatory penalties, or public backlash resulting from the subsidiary's actions can have a damaging effect on the parent company's image and credibility. As a result, the parent company must be vigilant in monitoring and managing the subsidiary's activities, ensuring adherence to the company's ethical standards and local regulations.

Alternatives to Setting Up a Foreign Subsidiary

While setting up a foreign subsidiary can be an effective strategy for international expansion, it is not the only option available to businesses. The alternatives include forming a foreign branch, entering into joint ventures or strategic alliances, and partnering with an Employer of Record (EOR).

Discover the best ways to carry out global expansion - either via an EOR or opening a subsidiary here.

Forming a Foreign Branch:

A foreign branch is an extension of the parent company in a foreign country and is not a separate legal entity. Operating under the parent company's name, the foreign branch is subject to the same liabilities as the parent company, and its activities are taxed as part of the parent company's income.

Advantages:

• Simpler management: A foreign branch is easier to manage as it operates directly under the parent company, avoiding some complexities that come with managing a separate legal entity.
• Greater control: The parent company retains direct control over the foreign branch's operations, making it easier to maintain consistent standards and practices across the organization.

Challenges:

• Liability exposure: Since the foreign branch is not a separate legal entity, the parent company is fully responsible for its debts, legal obligations, and financial liabilities.
• Tax implications: The foreign branch's income is taxed as part of the parent company's income, potentially leading to higher tax rates and double taxation issues.

Joint Ventures and Strategic Alliances:

A joint venture is a separate legal entity formed by two or more companies to achieve a specific business objective. In a strategic alliance, companies collaborate on specific projects or initiatives without creating a new legal entity. Both approaches allow companies to pool resources, share risks, and leverage each other's strengths.

Advantages:

• Shared risk and investment: Partners can share the costs, risks, and responsibilities associated with the venture or alliance, reducing the financial burden on each individual company.
• Access to local knowledge: Partnering with a local company can provide valuable insights into local markets, business practices, and regulatory requirements.
• Faster market entry: Joint ventures and strategic alliances can help companies enter new markets more quickly by leveraging existing infrastructure, networks, and resources.

Challenges:

• Loss of control: Sharing control with partners may limit the parent company's ability to make unilateral decisions and enforce its corporate policies.
• Potential conflicts: Disagreements between partners can arise over issues such as profit sharing, decision-making, and intellectual property rights, potentially impacting the success of the venture or alliance.
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Partnering with an Employer of Record (EOR):

An Employer of Record is a third-party organization that handles various aspects of employment, including hiring, payroll, benefits administration, and compliance with local labor laws, on behalf of the parent company. Partnering with an EOR allows the parent company to have a workforce in a foreign market without establishing a physical presence.

Advantages:

• Reduced administrative burden: The EOR handles the complexities of hiring, payroll, and compliance with local labor laws, allowing the parent company to focus on core business activities.
• Faster market entry: Partnering with an EOR can expedite the process of entering a foreign market, as it eliminates the need to establish a legal entity or navigate complex local regulations.
• Flexibility: The parent company can scale its workforce up or down as needed, without the long-term commitment that comes with setting up a foreign subsidiary.

Challenges:

• Reliance on a third party: The parent company must rely on the EOR to manage its workforce, which may limit control over employee selection, training, and performance management.
• Costs: Partnering with an EOR can involve fees and charges that may affect the overall profitability of the international operations.

How Skuad can help

Ultimately, the decision to establish a foreign subsidiary should be based on a careful analysis of the costs and benefits, as well as the risks and opportunities, of operating in a foreign country. 

However, with an Employer of Record like Skuad and the right strategy, you can hire employees or expand into any country of your choice without establishing a foreign subsidiary.

Skuad is a global employment and payroll platform with a worldwide reach of over 160 countries. Our platform streamlines the process of onboarding talent, managing payroll, and maintaining compliance with local employment laws and tax guidelines.

Furthermore, we manage your entire employment journey, enabling you to expand your business operations in a compliant manner while minimizing effort and providing exceptional HR administration. Discover more about Skuad by scheduling a demo today.

FAQs

Why would a company set up a foreign subsidiary?

A company may set up a foreign subsidiary for various reasons, such as expanding its global reach, accessing new markets and customers, diversifying its operations, reducing costs, accessing local resources or talent, and complying with foreign regulations or laws. It can also help the parent company mitigate risks associated with operating in a foreign country, such as political instability or currency fluctuations.

What is the role of a foreign subsidiary?

The role of a foreign subsidiary is to operate as a separate legal entity from its parent company, performing business activities in a foreign country on behalf of the parent company. The subsidiary is responsible for managing its own operations, including sales, marketing, production, distribution, and hiring of employees, while adhering to local laws and regulations.

What is a foreign subsidiary example?

An example of a foreign subsidiary could be Toyota Motor Manufacturing Canada, which is owned by Toyota Motor Corporation, a Japanese multinational automotive manufacturer.