Everything You Need to Know About Foreign Subsidiary

Global expansion is a lucrative opportunity to scale your business on the international scene. One of the most common ways to enter a foreign market is to establish a foreign subsidiary.

A foreign subsidiary comes with many benefits, like compliance risk mitigation and local tax incentives. However, it also exposes businesses to hefty fines, lawsuits, and reputational damages. 

In this blog, we’ll outline everything you need to know about foreign subsidiary, including the advantages and disadvantages of such a move, and possible alternatives. Let’s dive in!

What is a foreign subsidiary?

A foreign subsidiary is a company that operates overseas and is partially or wholly owned by a larger, parent company located in another country. To be classified as a foreign subsidiary, the parent company must own more than 50% of the foreign legal entity. 

Foreign subsidiaries function as separate legal entities and are entirely liable for their assets and taxes. Moreover, these foreign legal entities must comply with the laws of local jurisdictions. 

Should you set up a foreign subsidiary?

Whether or not you should set up a foreign subsidiary depends on the company’s long-term objectives. A thorough overview of the company’s financial, logistical, and management aptness should be done to figure out which country will be the best “fit” for a foreign subsidiary.

If your company seeks to expand across borders, target a foreign market, and increase revenue, setting up a foreign subsidiary should be considered. In such instances, the myriad of opportunities that the foreign subsidiary will provide will offset any incurring risks. 

When should you establish a foreign subsidiary?

Establishing a foreign subsidiary is an excellent strategy if the target market has been researched and validated, and the company is ready to commit to long-term investments. 

Foreign subsidiaries make sense in the event of planning to hire employees in a specific foreign location, or when companies want to enhance their presence in the target market. Nevertheless, all aspects of market access should be taken into account before setting up a foreign subsidiary. 

Advantages of setting up a foreign subsidiary

If executed at the right time during the international expansion strategy, setting up a foreign subsidiary can prove to be highly beneficial for your company. Here are the four main benefits of establishing a foreign subsidiary. 

1. Local Financial Benefits

International subsidiaries can take advantage of local benefits, such as a financial grant for doing business operations in-region, or advantageous tax compliance laws. 

In addition, the parent company can benefit from sharing tax responsibilities, as the foreign subsidiary holds liability for its corporate tax. The parent company is exempted from paying taxes if it reinvests the revenue received from the dividends back into the foreign subsidiary. 

2. Lower risk for the parent company

As the foreign subsidiary is an independent legal entity, the parent company isn’t liable for the risks of doing business abroad. In case a third party issues a lawsuit against the foreign subsidiary, the parent company remains protected. 

Despite this isolated foreign subsidiary liability, the parent company can still remain in control of the strategy and operations of the subsidiary. 

3. Workload diversification

Another advantage of setting up a foreign subsidiary is splitting the growing amount of responsibilities that ensue with global expansion. For example, the parent company can set all revenue streams to flow from one location through the foreign subsidiary. 

Moreover, the foreign subsidiary can be used as a platform to manage a specific product under its own brand voice. In this way, the focus can be on more specialised tasks which creates a more manageable workload. 

4. Building trust in a new market

A foreign subsidiary boosts the legitimacy of your business and showcases that you’re dedicated to creating business relationships in-region. 

Additionally, businesses can utilise the local reach of foreign subsidiaries to promote new products, services or sub-products. Certain products or services might be more aligned with the local’s needs, thus, they will perform better in a foreign market. 

Disadvantages of setting up a foreign subsidiary

While foreign subsidiaries come with noticeable advantages, the process of establishing one can cause manifold of complexities. In this section, we will break down some of the potential challenges that you might have to overcome. 

1. Costly and time-consuming

What discourages many companies from building global teams is the high cost and lengthy process of establishing a foreign subsidiary. The preparation itself requires several months of meticulous research and sizable setup investments. 

In addition, senior management must dedicate time and energy to maintain the foreign subsidiary’s operation after the initial setup. As a result, attention will be detracted from other high-return operations. 

2. Compliance risk

Navigating the local tax and legal systems can be daunting and puts your business at risk of compliance. Failing to comply with local labour laws and regulations can lead to non-compliance penalties and fines.

The international subsidiary should have access to HR services that offer local expertise. Native Teams’ EOR and PEO solutions will ensure full compliance with local tax requirements, managing payroll, and benefits packages. 

3. Difficult to dissolve

If the investment fails to deliver results, you may have to dissolve the foreign subsidiary, which can be time-consuming and costly. In fact, closing the foreign subsidiary down can take double the time than establishing one in the first place. 

In the process of dissolving, foreign subsidiaries must consider numerous steps, such as closing bank accounts, giving employees notice, dissolving lease agreements, and liquidating investments. 

4. Cultural differences

Cultural norms differ across countries, which impacts daily business operations. The parent company must adjust to the cultural norms of the foreign subsidiary’s host country and create different work schedules or methods of task completion. 

In addition, factors like language barriers, time zones, and body language can exacerbate conflicts and miscommunication between team members from different countries. 

Alternatives to establishing a foreign subsidiary

Businesses that want to expand globally but aren’t ready for the commitment of setting up a foreign subsidiary have other flexible options. Some of the most popular alternatives include engaging contractors, partnering up with an employer of record service provider and establishing foreign affiliates. 

Engaging contractors

For businesses that are solely testing the waters of a foreign market, engaging international contractors would be more beneficial than establishing a foreign subsidiary. 

By hiring contractors ad-hoc from anywhere in the world, you can benefit from their specialised skills while reducing costs and exposure to lawsuits. However, it can also cause misclassification risks if there’s no alignment with the local worker classification laws. 

Partnering with an EOR

Another way to expand into foreign markets is to partner up with an employer of record (EOR). When using EOR services, you want to enjoy the benefits of entity establishment, without the costly upfront costs and the time-consuming registration. 

Partnering with an EOR service provider will ensure quick onboarding for the new employees, benefits administration, and compliance while you manage the daily tasks and responsibilities. 

Establishing foreign affiliates

With foreign affiliates, the parent company has a minority stake in the investment. This means the financial and reputational risk is much lower than with foreign subsidiaries. 

The downside of foreign affiliates is that it doesn’t allow the same degree of control as a foreign subsidiary. Plus, there are tax disadvantages as losses in one affiliate can’t be offset with the profits of another to decrease the tax burden of the group. 

Wrapping up

Setting up foreign subsidiaries requires careful planning, market research, and consulting with experts in legal, financial, and cultural aspects. By weighing the benefits and drawbacks and making informed decisions, businesses can leverage the opportunities offered by foreign subsidiaries to expand their global presence.