What is a Foreign Subsidiary?

What is a Foreign Subsidiary? Examples and Alternatives for Global Expansion

What is a foreign subsidiary and what options does it provide for the holding company? Read our guide and decide if launching a foreign subsidiary is the next step for your company.

Anja Simic
Written by Anja Simic
September 28, 2021
Contents
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Today, aspiring companies often establish some form of office in another country. These representations of a business entity in a foreign country can be branches or subsidiaries.

Recently, due to globalization, more companies than ever before are looking for the best option for international expansion. Establishing a foreign subsidiary is an important step to improve a business’s reach into new markets as well as getting tax benefits.

What is a foreign subsidiary?

A foreign subsidiary is a business entity that is owned to a certain degree by another entity from a foreign country. Another name for a subsidiary company is the daughter company. The company owning the foreign entity is called the holding company or a parent company.

Even though a parent company can own 100% of the daughter company, they are not a single entity. The subsidiary is a separate legal entity from the holding company as far as all tax and liability matters are concerned. However, the holding company influences the ways of doing business: policies, decisions, and plans the subsidiary implements, proportional to the parent company's ownership stake in the subsidiary. Also, if this ownership is less than 50%, the foreign entity is called an affiliate company.

The financial relationship between a holding company and its subsidiary

A foreign subsidiary is an asset of the parent company and will show up on the parent company’s annual balance sheet. However, it can be difficult to translate the assets from a foreign currency into the home country’s currency.

Additionally, a daughter company will usually operate using a different set of bank accounts from its holding company, since it is in another country. Foreign subsidiaries are usually not subject to US income tax, since the IRS does not consider this type of business as a US company, even if they are wholly owned by a US business. A foreign subsidiary pays taxes according to the laws of the host country, or the country in which they reside.

As long as the laws and regulations of the host country allow businesses to establish subsidiary companies, the parent company does not need to establish a branch office–this new daughter business is enough.

What are some examples of subsidiary companies?

One of the most famous examples of a subsidiary company is Instagram. Instagram was acquired by Facebook in 2012 (which became Meta in 2021), and while they do function as different entities, Instagram is a wholly-owned subsidiary of Meta. The same applies to the Whatsapp messaging app. Likewise, Google LLC and Google Nest are subsidiary companies of Alphabet Inc.

Most products (especially in the food industry), are manufactured by subsidiary companies of a small number of prominent, multinational companies. For example, KFC, Pizza Hut, and Taco Bell are all subsidiary companies of Yum! Brands.

Branch office vs. subsidiary

A branch office is a part of the parent company, set up in another area of the world. The foreign branch is dependent on the parent company and executes all of the same business activities as the parent company. Think of it as a satellite office: it's physically still in another location, but functionally (and legally) operated by the parent company.

A subsidiary, on the other hand, is a legally independent entity. While control still lies with the parent company, the subsidiary enjoys much more independence as it conducts its own business operations, governs itself, and takes into account all of the laws and regulations of the host country (which can vary greatly from those in the home country.

Permanent establishment vs. subsidiary

The existence of your subsidiary doesn’t count as permanent establishment (PE) by default. However, to make sure you’re not running a risk, check if your subsidiary meets these criteria:

  • It’s a fixed place of business

  • It generates income for the parent company

  • The parent company controls the subsidiary’s activities

If you checked all three factors, your subsidiary is like a PE and your taxes may increase substantially. Read our PE ultimate guide to learn more about permanent establishment risk and how to avoid it.

Pros of establishing a foreign subsidiary

There are many advantages to launching a subsidiary in a new country. Apart from reaching new and interesting business opportunities, there are various tax benefits as well as opportunities for global expansion.

Access to new markets and global hiring

A foreign subsidiary gives the parent company a chance to introduce its product or services to new, lucrative markets all over the world. It also helps you hire full-time employees abroad directly, without a middleman, such as an employer of record.

Alignment of company culture

A parent company chooses the board of directors, so it is easier to transition the daughter company into the holding company’s corporate culture and values.

Control over the new company’s business activities

If the parent company has a controlling interest in a foreign subsidiary, it has a great influence on the decision-making process for the subsidiary’s plans and business activities. This enables the parent company to better execute business strategies in accordance with its wishes and plans.

Diversification of workload

Subsidiaries help manage the ever-growing activities of an expanding company. The workload can be split into smaller groups and delegated to daughter companies allowing both domestic and foreign workers to remain completely focused on smaller tasks. Thus making the entire workload more easily manageable.

More credibility in the new market

Companies that launch a subsidiary in a certain country are likely to be taken more seriously by businesses in that country. Not to mention the government and the local industries in general. This is because local companies are more likely to do business with a foreign subsidiary that is registered locally, and has legal and fiscal assets in the country in which it is doing business.

Limited liability for the holding company

A parent company has limited liability for the business operations of its foreign subsidiary. This means the parent company has a great deal of control while taking very few risks.

Resale potential if things don’t go according to plan

If a subsidiary company is not meeting the holding company’s standards, the holding company can choose to sell it and get its investment back.

Foreign Direct Investment (FDI) opportunities

A company that provides foreign direct investment does not just bring money into the host country, it provides valuable technical and business knowledge and skills. This is a great benefit for any host country.

Cons of establishing a foreign subsidiary

While it can be incredibly beneficial to parent companies to acquire subsidiaries in foreign countries, there are some downsides to it, as well. These disadvantages are mostly related to setting up a foreign subsidiary and navigating it in accordance with all of the plans of the holding company.

Length and costs of the process

Properly setting up a foreign subsidiary takes a lot of time. The preparation and planning alone can last for months or even more.

Additionally, the costs of acquiring and successfully running a business in an entirely new market will require meticulous research and a sizable investment.

While the payoff is definitely worth it, not all companies can afford the initial investment of both time and financial resources, especially if you're planning to expand to several new markets or hire from multiple foreign countries.

Cultural and scheduling differences

Being a part of an international business means that a company will have to get used to various different business cultures and approaches to task completion. Since foreign subsidiaries are usually staffed with employees from the host country, management from the holding company might encounter some conflicting schedules and holidays.

However, if the incorporation of a foreign subsidiary is done correctly, these problems should not present anything more than minor challenges.

Increased bureaucracy

Making decisions on a company level can become demanding, as it has to go through various levels of both the parent and the daughter company.

Additionally, sometimes conflicting international tax laws and other regulations apply for the holding company and the subsidiary because they are in different countries.

These things mean that the shot-calling process will take significantly longer than it usually does and it will require more people to be a part of it. Finally, both companies might need to hire a legal team to overcome the legislation differences in both countries.

Difficulty in finding the right staff

Staffing can be remedied by outsourcing the talent acquisition to an employer of record or a professional employment organization (PEO) and letting trained professionals with extensive knowledge of the laws and customs in the host country choose the best candidates for any job opening in the subsidiary company.

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Get the paperwork going, or choose an alternative with Deel

Once all the pros and cons have been put on paper, it seems that there is more to gain than to lose by launching a foreign subsidiary. However, all the advantages can turn into problems if the new business isn’t properly acquired and set up.

Luckily, there are a few alternatives that will allow a business to get some of the benefits of foreign subsidiaries (such as establishing a presence in new markets), while limiting the potential risks of acquiring a subsidiary. One of them is to hire foreign contractors or operate through an EOR.

Deel allows any business to hire anyone, anywhere in the world while remaining in complete compliance with the local laws and regulations. You can effortlessly build a global team and let us manage the contracts, tax forms, payments, benefits, and more - all in one platform.

Want to learn more about how Deel works? Request a demo today.

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