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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Establishing a foreign subsidiary is essential in improving a business’ reach into new markets and gaining tax benefits and incentives. Today, aspiring companies looking for international expansion establish some form of office or branch in another country.

What is a foreign subsidiary?

A foreign subsidiary is a business entity wholly or partially owned by another entity from a foreign country. Another name for a subsidiary company is a daughter company. If the parent company owns less than 50% of the foreign entity, it’s called an affiliate company.

The company owning the foreign entity is called the holding company or 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.

Despite the subsidiary being a separate legal entity, the holding company can still control how the subsidiary operates proportional to the parent company’s ownership stake in the subsidiary. The holding company typically implements policies and makes decisions on behalf of the foreign company.

The financial relationship between a holding company and its subsidiary

A foreign subsidiary is an asset of the parent company and will be visible on the company’s annual balance sheet.

A subsidiary will usually operate using a different set of bank accounts from its parent company since it is in another country.

Foreign subsidiaries are usually not subject to US income tax. This is because the IRS does not consider this type of business a US company, even if a US business wholly owns them.

A foreign subsidiary pays taxes according to the host country’s laws 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. The subsidiary business is sufficient.

What are some examples of subsidiary companies?

A famous example of a subsidiary company is Instagram. Facebook (which became Meta in 2021) acquired Instagram in 2012. While they function as separate entities, Instagram is a wholly-owned subsidiary of Meta. Whatsapp is also a subsidiary of Meta.

Similarly, Google LLC and Google Nest are subsidiary companies of Alphabet Inc.

Many food industry manufacturers are subsidiaries. For example, KFC, Pizza Hut, and Taco Bell are all multinational subsidiary companies of Yum! Brands.

Branch office vs. subsidiary

A branch office depends on the parent company, while a subsidiary is legally independent of the parent company.

A branch office is part of the parent company, set up in another country. The foreign branch depends 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 in another location but functionally (and legally) operated by the parent company. With a branch, you can use the same tax return as the parent company and benefit from tax agreements that stop you from paying duplicate taxes in both locations.

A subsidiary, on the other hand, is a legally independent entity. While control still lies with the parent company, the subsidiary has much more independence. It conducts its own business operations and governs itself. It must also consider all of the local laws and regulations of the host country, which can vary significantly from those in the home country. A foreign subsidiary also has greater tax obligations and must file separately for the subsidiary as its own entity.

Permanent establishment vs. subsidiary

A subsidiary is a foreign entity governed broadly by the tax authority in its home country. In contrast, a permanent establishment is a foreign entity that relinquishes some tax authority to the host country.

A permanent establishment is an international tax concept. Many countries adopt the concept to regain some tax control over foreign entities that may intentionally or unintentionally commit tax avoidance in the host country

A foreign entity can attain or be assigned permanent establishment status if it meets the following criteria:

  • It maintains a fixed place of business in the host country

  • The company is a dependent agent meaning the parent company habitually exercises the authority to conclude contracts on the foreign entity’s behalf in the host country
A foreign subsidiary may fall into the category of a permanent establishment if it begins to “act” as a dependent agent of the parent company.
 
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.
 
When a foreign entity falls into the category of a permanent establishment, the host country claims the right to assess and apply local taxes on the company’s business activity. These local taxes could include income tax on profits, VAT, sales tax, employment tax, and other excise taxes. PE may also require the entity to register locally and trigger payroll and corporate tax compliance requirements.
 

An example of a permanent establishment would be a fashion company with corporate headquarters in their home country and a factory in a foreign country. The factory is a fixed place of business, and the headquarters exercises authority over it. In this scenario, the factory is a permanent establishment and must pay taxes in both territories.

To avoid being a dependent agent, there are two conditions:

  • The foreign entity must be both legally and economically independent of the enterprise

  • The foreign entity must be acting in the ordinary course of its business in carrying out activities on behalf of the enterprise

Pros of establishing a foreign subsidiary

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

Access to new markets and global employment

A foreign subsidiary gives the parent company a chance to introduce its product or services to new, lucrative markets worldwide. It also enables the company to hire full-time employees abroad without using 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 assimilate the subsidiary into the holding company’s corporate culture and values.

Control over the new company’s business activities

Establishing a foreign subsidiary gives the parent company control over a foreign entity. This means that the parent company can influence the decision-making process and execute business strategies that align with the parent company’s plans and goals.

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. This allows domestic and foreign workers to focus on smaller tasks, thus making the entire workload more manageable.

More credibility in the new market

Companies that launch subsidiaries in a particular country are likely to be taken more seriously by local businesses and governments. Local companies are more likely to do business with a foreign subsidiary registered locally, with legal and fiscal assets in the country where 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 fails to meet the standards of the holding company, the holding company can sell it and get its investment back.

Foreign Direct Investment (FDI) opportunities

A company that invests in a foreign country brings valuable technical business knowledge and skills to attract foreign investment

Cons of establishing a foreign subsidiary

While establishing subsidiaries in foreign countries can be incredibly beneficial, there are some challenges to consider. The disadvantages primarily relate to navigating the foreign subsidiary per the holding company’s plans.

Length and costs of the process

Properly setting up a foreign subsidiary takes much time. The preparation and planning alone can last for months or longer.

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 typically worth it, not all companies can afford the initial investment of time and financial resources. This is especially true if you’re planning incorporation into several new markets or hiring from multiple foreign countries.

Cultural and scheduling differences

Being a part of an international business means that a company will have to adapt to different business cultures and approaches to task completion. Since business owners usually staff foreign subsidiaries with employees from the host country, management from the holding company might encounter conflicting schedules and holidays. With prior planning and execution, these conflicts can be easily remedied. 

Increased bureaucracy

Making decisions on a company level can become demanding, as they’ll have to go through various levels of the parent and daughter company.

Additionally, sometimes conflicting international tax laws and other regulations apply to 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 require more people to participate. 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 (EOR) 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 you’ve weighed all the pros and cons, it seems 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, a few alternatives 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 compliant 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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