What is a Foreign Subsidiary?
Erez Greenberg| Sep 13, 2022
- Foreign subsidiary advantages include: financial grants, reduced risk, division of responsibilities
- Disadvantages include: investment costs, complexity of closing
- A foreign subsidiary is 50%-99% owned by the parent company, but is a separate legal entity
- Operating alternatives include: permanent establishment, overseas branch, affiliate
Expanding your business to a new location can be an intelligent way to grow revenues, open your product or service to new markets, and take the next step for your organization. However, there is no such thing as a one-size-fits-all approach to global expansion.
To comprehend the significance of foreign subsidiaries, it’s crucial to first grasp the broader concept of a foreign entity. A foreign entity refers to an organization or legal entity that operates in a country other than its home base, encompassing a diverse array of entities such as companies, governments, and nonprofits.
Now, let’s delve into the specifics of foreign subsidiaries, uncovering how they fit into the tapestry of international business and their role in the corporate landscape.
A foreign subsidiary is a company that operates overseas, owned by a larger company that is based in another country – also known as a parent firm or holding firm. Such a legal entity shall be considered as a foreign subsidiary only if your parent company owns more than 50% of its share capital. The foreign subsidiary holds full liability for its own taxes and debts and owns its own assets, and needs to ensure its complete compliance with local laws and regulations.
If you’re considering opening a foreign subsidiary, this article will answer all your ‘need to know’ questions before you begin.
Advantages of Foreign Subsidiaries
Why might a business choose to open a foreign subsidiary? There are many advantages and disadvantages for a foreign subsidiary, but let’s look at three main benefits.
1. Local Financial Benefits
First, it’s a financially smart approach to overseas expansion of your business. By establishing a foreign subsidiary, your business can take advantage of local benefits, for example, a financial grant that rewards your company for doing business in-region, or tax or compliance laws that are advantageous. In the UAE for example, there are many favorable terms for opening a business, which you can benefit from if you launch a presence locally.
One recent company to open a subsidiary in the UAE is FTX FZE, which is a subsidiary of crypto exchange FTX. The laws around cryptocurrency vary between regions, with legislation catching up with the market in the US.
In addition, as the foreign subsidiary has its own corporate tax responsibilities, the parent company can also benefit from splitting tax requirements, paying a lower tax bracket overall by sharing the load between two governments.
2. Less of a risk for the parent company
Second, a foreign subsidiary is a separated and independent legal entity. That means that in most cases the actions of a foreign subsidiary won’t bind the parent company, unlike some other global expansion choices. The parent company can still control the strategy and businesses of the foreign subsidiary, but the foreign subsidiary liability is isolated so that it can mostly impact the new business of the foreign subsidiary, not the parent company.
If you’re thinking about companies with foreign subsidiaries, one good example is Meta, which has a famous subsidiary in WhatsApp. If WhatsApp was sued, the liability would be more difficult to transfer to the parent company, Meta.
3. Division of Responsibilities and Workload
Another plus of a foreign subsidiary is that it allows you to separate out different responsibilities between your parent company and its subsidiary, flowing all revenues from one region through the foreign subsidiary for example, or creating a foreign subsidiary to manage a specific product or service under its own brand or voice.
4. Better Investment Potential
An expanded business which includes foreign subsidiary is a great sign to investors that your business is doing well, and can encourage more influx of capital and support. If at any point the foreign subsidiary is not doing well, or the business needs to raise capital for the parent company, you can easily shut down the foreign subsidiary without a heavy impact on your business as a whole.
5. Generating Trust in a New Market
Finally, many other business entities and companies may not want to do business with you without a local presence, so a foreign subsidiary shows you’re serious more than simply remote hiring. Local governments, municipalities, organizations and even customers may be wary of entering into commerce and contracts with a foreign company, while a local foreign subsidiary adds legitimacy to your business and proves you’re serious about setting up relationships in-region.
A foreign subsidiary can also help you to differentiate a new product or service, or a sub-product from other products or services of your business. For example, Tiffany and Co is a subsidiary of LVMH, better known as Louis Vuitton (Moët Hennessy), but the jewelry brand stands on its own with its own name and reputation.
Disadvantages of Foreign Subsidiaries
1. Higher Costs and Time Investment
On the negative side, setting up a foreign subsidiary is a complex process. You’ll need to invest heavily in making it work, both in terms of time and money, and once it’s set up, maintaining the subsidiary also requires additional efforts.
If you don’t have local expertise, you might find yourself coming stuck, as opening a foreign subsidiary requires an understanding of the local legal, tax-related and cultural requirements and expectations in the new country. Without this, you expose yourself up to compliance risk, so most companies will opt for consulting with local expertise – which can add up fast.
2. Cultural Differences
It’s also important to think about the cultural differences that may arise between the parent company and the foreign subsidiary. For example, different regions won’t have the same holiday calendar, so you won’t be able to offer company-wide vacation days or public holidays and expect them to be the same. This can cause scheduling issues or conflict in collaboration and communication, exacerbated by time zones, language barriers and more.
3. More Complex to Close Down
No one wants to think about the worst-case scenario, but it’s also important to recognize what might happen if the foreign subsidiary won’t be successful. After all the hard work efforts of setting it up, it can take the same or even more time to close it again. The checklist will include dissolving leases and investments, closing bank accounts, giving employees notice, and more legal and business requirements under the local legislations..
How do Subsidiary Companies Work?
A foreign subsidiary is 50%-99% owned by the parent company, but is a separated legal entity that operates in foreign countries, thereby providing and allowing access to new markets and opportunities. It can split off from the parent company in terms of the services and products that it offers, and to the public, it might appear totally separate, providing the ability to create a new brand voice, for example.
On the back end, it can provide tax benefits to the parent company, such as lower tax rates than the company is regulated by in the home country, and it can also provide additional assets to the parent company, acting as a separate asset to the business which is legally separate.
To recognize whether a foreign subsidiary is the right choice for your business, you may want to learn a bit more about other options for international expansion.
Foreign Subsidiary Alternatives
Option 1: Foreign Subsidiary vs Overseas branch
An overseas branch is also known as a division of your company, and the main difference is in terms of your liability. While a foreign subsidiary is a different legal entity and totally independent in terms of liability and financial responsibility, an overseas branch is totally dependent on the parent company.
There are two main kinds of overseas branch – (1) a representative office, where you can send workers abroad but can’t enter into any contracts or generate income, and (2) a branch office which provides more freedom to make money, but will still be legally and integral part of your parent company. You would choose an overseas branch when you don’t want to separate out legal or financial liability, and a foreign subsidiary when this separation of liability is important to your business.
Option 2: Foreign Subsidiary vs Permanent Establishment
Permanent establishment is a tax concept which decides whether a company needs to pay full corporate taxes in the region in question.
Generally speaking, a foreign subsidiary would pass the permanent establishment criteria, so it’s important to be clear on the rules to avoid non-compliance. A company is considered to have permanent establishment if it holds a permanent office in the region, that office generates revenue for the parent company, and the parent company has control over the activities that the local office completes.
There are differences in terms of how your company will be taxed if they pass the permanent establishment test or not. For a foreign subsidiary without permanent establishment, distributed profits will be subject to tax withholding.
However, when permanent establishment has been proven through the criteria listed above, this means the business will need to pay tax for all revenues in the location where the office resides. Without a double taxation treaty this can incur heavy costs for the parent company. With a double taxation treaty in place, the taxation of profits will fall where the permanent establishment is based.
Option 3: Foreign Subsidiary vs Affiliate
Many of the legal laws and regulations that apply to foreign subsidiaries will rely on what percentage of that company is owned by the parent company. As mentioned above, a parent-subsidiary structure is when the parent company owns 50%-99% of its share capital. If 100% of the share capital of the company is owned by the parent company, this is a wholly-owned subsidiary. However, if less than 50% of the share capital of the company is owned by the parent company, this is an affiliate (also known as partly owned subsidiary) and in such cases, the parent company is a minority shareholder.
The main reason for this approach would be to limit the negative attitudes towards a local business that is majority owned by a foreign company. By becoming an affiliate, the parent company is not seen to have overall control, and the affiliate is more likely to be viewed as its own separate entity.
Option 4: Foreign Subsidiary vs Global PEO
A Global PEO, similar to an Employer of Record, can take on the hiring of foreign employees for you, sidestepping the complexities of setting-up a foreign subsidiary. If you’re testing the waters in a new region, only have a handful of employees working abroad, or if you want to compliantly and expertly start working internationally, a global PEO could well be the right choice.
|Global PEO||Foreign subsidiary|
|Set up and on-site requirements||The Global PEO has an established local presence||Register with local authorities, set up tax requirements, find an office, fill out all documentation, etc.|
|Banking||The Global PEO will pay salaries, etc. to all employees on your behalf. You will pay one monthly fee to the Global PEO.||Need to set up bank accounts and register locally and create a payroll process from scratch, including all local deductions and withholdings.|
|Compliance||Local expertise by the Global PEO||Need to research independently or pay for external consultation|
|Hiring||Not included||Not included|
|Local director||Included as part of the Global PEO business.||Need to assign. May need a resident locally|
|Benefits||Handled through pre-existing local relationships||Create individual partnerships with healthcare providers, pension funds, and other benefits services|
Does your Business Need a Foreign Subsidiary?
By using a holistic payroll platform with direct relationships, you can sidestep a lot of the complexity of expanding your business to a new region/s. Papaya has direct relationships with fully-vetted EOR providers in more than 160 locations across the world, and can help you to compliantly and quickly hire new employees abroad, or shift freelancers to become full-time employees to avoid the risks of misclassification.
When you enter into a single relationship with Papaya, you gain the ability to hire locally on a global scale with almost no setup costs, comply with all requirements for benefits and taxation via partnerships with local expertise in all regions in which you do business, and benefit from Papaya’s AI-driven compliance engines to ensure total accuracy and peace of mind. Contact us for more details.
What are the types of foreign subsidiaries?
There are 3 types of subsidiaries, wholly owned, affiliate (also know as partly owned), and a joint venture subsidiary. If the parent company owns 100% of the company then the company is considered to be a wholly-owned subsidiary. If the parent company owns less than 50%, usually between 20%-49% then the company is an affiliate. And if two companies creates the subsidiary where each one owns 50% of it, then its considered a joint venture.
How are foreign subsidiaries managed?
Once a foreign subsidiary has been established, the parent company will need to appoint a board of directors to manage the day-to-day business and strategy of the foreign subsidiary. The foreign subsidiary may need to appoint a local director to ensure compliance with local laws and regulations, employment laws for the subsidiary employees, and filing and documenting the right taxes and forms.
What are the operational accounting options with foreign subsidiaries?
Foreign subsidiaries that are more than 50% owned by the parent company, often consolidate their financial accounting records and results with the parent company. When the company is an affiliate, (less than 50% owned) their operational accounting will usually be unconsolidated, and its own records will be kept and separated out. Remember, generating revenues for the parent company is one criteria of permanent establishment.
Why would a company set up a foreign subsidiary?
A foreign subsidiary helps a company expand its presence to a new region. They can find more customers, generate greater revenues, open their product or service to new regions, or start a separate business with the clout and support of the parent company to help hit the ground running.
How much risk does a subsidiary present to the parent company?
A subsidiary is a separate business from the parent company, and has its own liability, separate from the parent company. The foreign subsidiary has its own board of directors and management teams and in general, it cannot assume financial liabilities to the parent company. However, companies should be aware that reputational damage and brand damage can still impact the parent company if their subsidiaries come under scrutiny.
What is the difference between a subsidiary and a franchise?
A subsidiary is 50% owned by the parent company, while a franchise is a legal agreement by the parent company to allow another business to use its name and open up a branch of its business. The franchise will dictate certain rules the business has to keep to, but it will not be owned by the parent company. The parent company will receive royalties, but the business with the franchise will pay the unit costs of running the franchise.
Can a private company have a public subsidiary?
Yes. A private company can hold shares in a public company, and if they own more than 50%, this will make them the parent company for a public subsidiary.
Can a subsidiary company hold shares of its parent company?
No, a subsidiary cannot hold shares in the parent company that owns its business, as this could lead to a conflict of interests between these two entities. As the foreign subsidiary is owned and governed by the parent company, they are not allowed to hold shares, and any transfer of shares is immediately void.
What is unrecognized deferred tax liability?
Unrecognized deferred tax liability occurs when a company with a foreign subsidiary reinvests its revenues overseas to the subsidiary. They will need to include this revenue in their returns, but they don’t need to pay tax on it until they bring those earnings back to their home country, or until the subsidiary is dissolved. On the balance sheet, these earnings will come under the title unrecognized deferred tax liability.