A foreign subsidiary is a company owned or controlled by a parent company headquartered in another country. The parent company holds a majority stake (more than 50% and up to 100%) in the subsidiary, allowing it to influence or control business operations, strategies, and decisions.
Because it is a separate legal entity from its parent company, a foreign subsidiary must comply with the local tax and employment laws.
There are numerous ways for a business to enter a foreign market. Establishing a foreign subsidiary enables businesses to expand internationally, establish a local presence in global markets, and agilely navigate local laws and regulations while maintaining control from the parent company’s base of operations elsewhere. However, establishing a foreign entity exposes the business to various risks and requires significant time and money.
Key features of foreign subsidiaries
A foreign subsidiary has unique qualities that differentiate it from a foreign branch or permanent establishment of a parent company.
- Ownership and control. The parent company holds a controlling interest in its foreign subsidiary, ranging from over 50% to 100%. The parent company makes strategic business decisions, while the foreign subsidiary manages day-to-day operations in the host country.
- Separate legal entity. Operating independently under the host country’s laws, a foreign subsidiary has its own liabilities, tax obligations, and governance structure—separate from the parent company.
- Local talent. A foreign subsidiary employs local talent to better integrate into the market and comply with employment laws.
- Financial reporting. A foreign subsidiary maintains separate financial records from the parent company. However, it typically consolidates reports with the parent company for global accounting purposes.
Foreign subsidiary vs. foreign branch
Note that a foreign subsidiary differs from a foreign branch: A parent company owns 100% of a foreign branch and is liable for all branch operations. As an extension of the parent company, a foreign branch can only source talent by hiring contractors or relocating employees from its home country, which requires following complex immigration processes. A foreign branch also uses the same tax return as its parent company.
Foreign subsidiary vs. permanent establishment
A foreign subsidiary should not be confused with a permanent establishment. A permanent establishment is a business status that imposes various taxes on a foreign business with an ongoing presence in a foreign jurisdiction. Permanent establishment applies to a business with a fixed presence in the host country that acts as a dependent agent of the parent company.
The importance of foreign subsidiaries
A company seeking to do business in another country may choose to establish a foreign subsidiary instead of another type of venture for strategic reasons. A primary compelling reason for a parent company to create a foreign subsidiary is to mitigate financial and legal risks while maintaining control of the subsidiary.
Facilitates global expansion
Establishing a foreign subsidiary allows businesses that plan to develop a long-term presence in a host country to more effectively enter the market, attract local talent, and reach new customers in the host country.
Localized operations
A foreign subsidiary with operations in the host country makes it easier for the business to customize products or services and market them to meet the preferences and needs of the local market. Hiring employees from the host country who have local business experience and knowledge, as well as local professional networks, can ease entry into the new market.
Compliance with local regulations
A foreign subsidiary operates as a local entity. As such, it must comply with the host country’s legal, employment, and tax laws or risk punishment and reputational damage.
Rules governing the employment of talent vary significantly from country to country. The foreign subsidiary must follow employment law regarding hiring, termination, payroll, vacation and leave time, and benefits. In most cases, this requires hiring legal and human resources experts in the host country.
As a separate entity, a foreign subsidiary only pays taxes to the government of the host country, which may be lower than, higher than, or similar to tax rates in the home country. For example, a foreign subsidiary of a U.S. company does not have to pay taxes to the Internal Revenue Service (IRS) because the IRS considers it a foreign company. The parent company only pays taxes on the dividends it receives from the subsidiary as a shareholder. If the parent company reinvests that revenue into the subsidiary, it does not have to pay taxes.
In some cases, foreign subsidiaries may take advantage of local tax benefits in the host country, such as tax holidays, tax credits, and tax-exempt free economic zones.
Risk mitigation
By operating as a separate legal entity, a foreign subsidiary can shield the parent company from legal or financial liabilities incurred in the host country. The parent company remains protected if a foreign subsidiary is sued. Likewise, if a subsidiary violates a local law, only the subsidiary pays the fine.
Foreign subsidiaries are subject to the authority of the host country’s government, which can enforce employment contracts and address other legal matters through the host country’s court system.
Challenges of managing foreign subsidiaries
While establishing a foreign subsidiary may benefit the parent company for the reasons listed above, it also comes with challenges, including navigating the host country’s laws and regulations, managing cultural differences, and overcoming physical distance.
Compliance complexity and regulatory changes
Navigating local laws, tax regulations, and employment standards requires significant expertise in the host country’s tax and legal systems. The foreign subsidiary must have access to adequate legal consultation to ensure compliance with all local labor laws and avoid noncompliance penalties, such as fines and damaged business reputations.
In addition, changes to laws and regulations in the host country can disrupt operations and increase costs.
Operational costs
Establishing and maintaining a foreign subsidiary involves significant financial investment in infrastructure, compliance, and local talent. Preparation alone involves several months of meticulous research and a sizable upfront investment. In addition, a business must continue spending time and energy maintaining its foreign subsidiary after the initial setup.
If the foreign subsidiary is unsuccessful, it may need to be dissolved—a lengthy and costly process. In fact, it often takes much longer to dissolve a foreign subsidiary than to establish one. Even though the parent company is not responsible for compliance, it must provide foreign subsidiaries access to legal consultation to navigate steps like paying government and employee debts, tax clearance, deregistration, and establishing formal dormancy.
During the dissolution process, foreign subsidiaries must also consider steps like closing bank accounts, ending lease agreements, liquidating investments, and offboarding employees.
Distance and oversight
Managing operations from the parent company’s location can lead to coordination challenges and information gaps, especially if there is a significant difference in time zones.
If actively leveraged, though, video conferencing software, team communication platforms, and project management software may mitigate distance-related challenges and give the parent company greater insight into the day-to-day operations of its foreign subsidiary.
Cultural differences
Differences in business practices, language, and culture can impact communication and operations. The parent company must adapt to the cultural norms of its foreign subsidiary’s host country and accommodate different workday schedules, approaches to completing tasks, and communication styles.
In addition, if a parent company has more than one foreign subsidiary, it must avoid managing each subsidiary in the same way. Each subsidiary is unique, with its own history, culture, personnel, and value propositions, so a unilateral, top-down approach is likely not the most effective.
FAQs about foreign subsidiaries
1. Why do companies set up foreign subsidiaries?
- To expand into new markets, gain operational flexibility, and establish a legal local presence for compliance purposes.
2. How are foreign subsidiaries taxed?
- Subsidiaries are taxed according to the laws of the host country but may benefit from tax treaties between the host and home countries to avoid double taxation.
3. What industries commonly use foreign subsidiaries?
- Industries such as technology, manufacturing, retail, and pharmaceuticals often establish subsidiaries to tap into international markets and talent pools.
4. Can a foreign subsidiary operate independently?
- While subsidiaries have operational independence, strategic decisions are typically guided by the parent company.
5. How long does it take to establish a foreign subsidiary?
- The timeline varies by country. Depending on regulatory requirements and bureaucratic processes, establishing a foreign subsidiary can range from a few weeks to several months.
The high costs, time investment, and legal risks of setting up a foreign subsidiary deter many businesses eyeing global growth. Fortunately, there is a more flexible alternative.
Velocity Global’s Employer of Record (EOR) solution allows companies to expand across borders quickly without setting up a subsidiary. With our EOR solution, you can jumpstart your global business initiatives rather than wait months.
Velocity Global handles onboarding, payroll, benefits administration, compliance, and ongoing HR support for your distributed workforce in 185+ countries.
Contact Velocity Global today to learn how to quickly and cost-effectively expand to foreign markets and grow a global workforce.
