Should You Open a Foreign Subsidiary? The Definitive Guide
If your company is looking to expand abroad, you may be considering opening a foreign subsidiary. Our in-depth guide explains what a foreign subsidiary is, and the pros and cons of opening one.
Published on March 29, 2022
What is a foreign subsidiary company?A foreign subsidiary is a company that does business abroad, owned by a larger company based in another country — also known as a parent company or holding company. A foreign subsidiary is considered a distinct, entirely separate legal entity from its parent company, so it’s often referred to as a foreign entity, local entity, or local subsidiary. Operating independently from its parent company, a foreign subsidiary company is classified by the IRS based on the percentage of its stock held by the parent company:
- Usually, the parent company must hold more than 50% of the subsidiary’s voting shares to maintain a controlling interest.
- If the parent company holds 100% of the shares, that subsidiary is a wholly-owned subsidiary.
- If the parent company owns less than 50%, that subsidiary is an associate or affiliate company.
Subsidiary vs. branchUnlike subsidiaries, which are separate from the parent company, a branch office is an extension of the company itself. A foreign branch can do business in certain regions but is still 100% owned and operated by the parent organization.All a company would have to do to set up a branch office is find and rent office space then source workers to staff the location. They could do so either by paying local independent contractors or by relocating employees from the company’s home country. In contrast, setting up a subsidiary requires the parent company to transfer share capital, gather documents, register for business and trade licenses, create separate bank accounts, and more. Altogether, it can cost hundreds of thousands of dollars and take months to create a foreign subsidiary company. Because branches are much faster and cheaper to set up than subsidiaries, companies can use them to gain knowledge and test the waters of the local market before committing to establishing a subsidiary. Since a branch office is an extension of the company, corporate management has more direct control over decision-making, while subsidiaries require companies to split votes with other shareholders. Branch managers also cannot hire local employees. They have to either staff their office with expat employees from the country where the parent company is based or hire local workers as contractors. In order to bring domestic workers to the new foreign branch, management needs to apply for the appropriate visas for their employees and go through often complicated immigration processes. A company operating with a foreign branch office might need to pay taxes on the same revenue twice — once for the parent country and once for the foreign country. This double-taxation rule can make it much harder for companies with branch offices to manage their tax burden across international borders.
When does it make sense to open a local subsidiary?Whether or not opening a local subsidiary is the right move for you depends on your business’ present circumstances and future aspirations. Here are five situations in which opening a foreign subsidiary makes sense:
When you have multiple workers in a specific locationIf your team is distributed around the globe, it doesn’t make sense to go through the process of opening local subsidiaries. But having multiple remote workers in the same location — that may be worth the trouble. Having a guaranteed workforce available from the start ensures your subsidiary company can become fully operational much sooner than if you didn’t have those workers. Keep in mind that hiring and sourcing enough people to staff and run an entire subsidiary can be a real struggle that can take anywhere from several months to years. . If you already have folks on the ground or connections to local recruiting talent pools, staffing is already that much easier. The exact number of foreign workers that makes this decision make sense, though, will depend on your company’s budget — it could be as few as five workers or as many as 100. You may also want to reassign employees from your parent company to the subsidiary to help get the new company running. When hiring employees for your new subsidiary, you’ll also need to devise hiring processes, benefits, and employment contracts that comply with the laws and norms of that country. For example, if you’re setting up a subsidiary in Brazil, double-check Brazil’s employment laws or consult with lawyers specializing in compliance with Brazilian labor laws.
When your employees don’t want to be contractorsEmployees often want the benefits and stability that usually come—depending on their country—with being a full-time employee rather than a contractor. In that case, forming a local entity may be the best and only solution. Creating a foreign subsidiary allows you to grant your workers full-time employee status as well as the peace of mind that accompanies it. Full-time status can also simplify taxes for employees. Contractors are typically responsible for paying their own income taxes while full-time employees get their taxes withheld by their company and remitted to their local governments. To that end, your subsidiary should keep up-to-date on their tax obligations on behalf of their employees. In addition, if you hire workers as employees, you may become legally obligated to offer benefits like vacation and healthcare that workers are looking for. Check with the local governments of the countries where you’ll be hiring to determine which benefits are mandated and how the difference between employees vs. contractors is defined. For some countries where government-sponsored healthcare is available, for example, you probably won’t need to provide health insurance.
When you want to strengthen your presence in a locationBy opening a subsidiary, you’ll be able to build local relationships and work more efficiently than if you were running operations from abroad. Establishing a foreign subsidiary demonstrates a commitment to the area. Your subsidiary company will be taken more seriously by the local government since you’ll be paying taxes and contributing to the local economy and infrastructure. For example, a local subsidiary may be viewed more favorably than a “visiting” foreign company taking its profits back to its own country. A foreign subsidiary can build its brand and reputation directly in that country while working with other local businesses and paying its local taxes. Local subsidiaries are also considered local businesses, so they can access capital and funding from local banks and financial institutions. In addition, subsidiaries can enter nearby, new markets much more easily than from overseas, thanks to better-connected manufacturing, distribution, and supply chains. For example, a Germany-based subsidiary can quickly expand its business activities to the rest of Europe, e.g., Italy, France, and Denmark, due to proximity and the interconnected economy of the EU. Instead of working to import and export goods to the U.S., a local subsidiary allows the parent company to base operations in that region to save time and money.
When you want to minimize financial riskBecause the subsidiary is a separate entity from the parent company, there’s inherently less risk for the parent company during its global expansion. If the subsidiary is sued or violates some law, only the subsidiary takes the fall or pays the fine. Meanwhile, the parent company has limited liability and is protected from the consequences faced by a subsidiary.Another way that subsidiaries minimize financial risk is by offering the potential for an exit. If the investment in a subsidiary doesn’t pay off as well as hoped, the parent company can always sell its shares in the subsidiary, especially if someone owns the other 49%, for example. However, a sale can take a long time and involve lots of consultation with legal experts. In China, for example, it can take a minimum of 10 to 14 months. While the parent company may be safe, the subsidiary may need guidance and consultation from lawyers who are well-versed in the local laws. Even though compliance isn’t the parent company’s responsibility, the parent company should still make sure the subsidiary has access to legal help for navigating the tricky nuances and differences in hiring contracts, taxation, government processes, and more.
When you want to lower your tax ratesOpening a foreign subsidiary also allows your business to take advantage of tax benefits and incentives, including lower tax rates compared to those of your home country. As foreign corporations, subsidiaries pay their taxes to the local government, only considering the revenue generated in that country. If the parent company did business in that country without a subsidiary, they would be responsible for paying taxes for both that country and their own on all of their profits worldwide.For example, a foreign subsidiary of a U.S. corporation wouldn’t have to pay U.S. tax to the Internal Revenue Service because the subsidiary would be considered a foreign company, not a U.S. company. Its U.S.-based parent company would only need to pay taxes on revenue received because of the shares it holds. However, if that revenue is reinvested into the subsidiary, the parent company could pay no taxes on it.Even with lower tax rates, your subsidiary company will still need to pay foreign taxes. Since tax laws can vary widely across different countries, it’s best to consult with local tax experts and professionals on how to file and pay those taxes.
Remember: Opening a foreign subsidiary isn’t for everyoneWhatever your reasons to open the local subsidiary are, always remember to assess the risk and research possible costs and the amount of paperwork. If a subsidiary isn’t the right fit, there are other options: opening a branch office or working with a third-party Employer of Record (EOR) or Professional Employer Organization (PEO) — or using Pilot.
The information contained in this site is provided for informational purposes only, and should not be construed as legal advice on any subject matter.
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