A foreign subsidiary is one of the most flexible and risk-free ways to expand your business into a new location. If growth is the name of the game, and you’re looking to learn exactly how to approach global expansion using a foreign subsidiary – we’re delighted you found us!
This article is part of our guide on Global Payroll.
What is a foreign subsidiary?
A foreign subsidiary is a company that is owned or controlled by a parent company in another country. It has a completely distinct legal entity from its parent company and does not even need to engage in the same kinds of business.
Nike could open a foreign subsidiary in Japan that sells ice cream, and that would be totally fine. We’re not saying they should, but they could “Just Do It” if the right mood overtook them.
What’s more, as a foreign subsidiary is considered to be its own legal organization, if Nike’s ice-cream selling Japanese foreign subsidiary forgot to measure the waistlines of their employees each year (a real-life rule, according to the regulations of the bizarre local “Metabo Law”), only the subsidiary would be considered non-compliant. The subsidiary may be subject to a fine, but there would be no kickback on Nike themselves.
For an organization to have a foreign subsidiary, they do not need to own 100% of the shares in the new company. In fact, if they do – this is known as a wholly-owned subsidiary and could cause problems in certain regions, where specific business types cannot be wholly owned by organizations abroad. Anywhere from 51% to 99% will help you to avoid any challenges of this kind. Under 50%, and the subsidiary is actually an affiliate or an associate company.
Added advantages of using a foreign subsidiary
The main reason why organizations use a foreign subsidiary is to expand their current footprint and serve new locations. That means you can give your services and products a whirl in new markets, take advantage of tax breaks or foreign investments in a brand-new location, and make the most out of the local expertise, technology, and talent.
A US-based SaaS company might open a subsidiary in the Ukraine for example, knowing that it’s a great place to hire developers, and hoping to expand their customer base to Eastern Europe.
Disadvantages of using a foreign subsidiary
The main challenge for businesses looking to open a foreign subsidiary is the sheer time and resources that it takes to get one up and running, then maintain and manage it moving forward.
It can cost upwards of $15,000 to open a foreign subsidiary, and while some countries can offer a speedy setup of under 1 month, in countries such as Brazil – 8 months is the expected time frame. You’ll also need to set up a foreign bank account, register for local insurances, and keep up with complex local employment laws and regulations.
When should I open an overseas foreign branch instead of a foreign subsidiary?
In some cases, you might decide that opening an overseas branch is a better fit for your business requirements. This doesn’t have the same separation of liability as a foreign subsidiary does, but is often simpler, as it also doesn’t have the same requirements in terms of taxation.
You can usually file one single tax return for your company that covers your branch office, and if you have tax agreements in place between the two countries, you can also avoid double taxation.
Is a subsidiary considered Permanent Establishment?
Permanent Establishment (PE) is not considered for a separate legal entity, but that doesn’t mean your subsidiary can’t go over the line, leaving you open to added taxation and risk. Whether your subsidiary counts as a Permanent Establishment will depend on whether you are deemed to be generating income through the subsidiary for the parent company.
In most cases, setting up a subsidiary will involve creating a “fixed place of business” in your name, (factor #1) as well as revenue generation for the parent company (factor #2). If your parent company is managing the day-to-day activities of the subsidiary – that’s likely to be three strikes and you’re out.
This in practice means that the host country will tax your business at the usual rate. This isn’t a problem if you’re not paying taxes in the US – after all, you need to pay tax somewhere! Double Taxation laws will likely inform what decision you opt for; just make sure that you’re upfront about the purpose of your business and whether you are forming PE, so that you don’t end up with fines. Remember, Permanent Establishment taxes are connected to ongoing and persistent revenue generating business, so not an ad-hoc freelancer arrangement, or a one-off sale to a customer abroad.
What other options can I consider for international expansion?
If all the above options seem like too much hard work, but you’re ready to expand your business and start hiring internationally, there are a few other options that may suit your business for expanding to a new location.
- Employer of Record: Here, a local in-country partner who already has a presence will take on the employment on your behalf. You’re still the boss in all but name, deciding on when your employees work and how, but the EoR will often handle some local and cultural elements of the relationship such as benefits, paid-time-off, or insurance.
- Affiliate company: As we said before, if your parent company owns less than 50%, this means that the new entity is actually an affiliate or associate company. This can help to reduce the negative stigma that sometimes occurs when a company is owned by a foreign parent company. Unfortunately, it’s no less complex to set up and maintain – plus you lose some control along the way.
- Freelancers: If you’re not yet sure whether you want a whole team of full-time employees in the new location – why not test the waters with independent contractors? Hire them ad-hoc from anywhere in the world, choosing individuals with great references and reasonable terms that align with what you need. You still get a broader talent pool and access to the new region – without any of the commitment up-front.