The years following 2020 will be remembered as the time when work was liberated from the confines of the office and even the country. Many businesses are going international and opening branches in other nations as the world becomes a smaller place. Establishing a foreign subsidiary is a common way for businesses to expand internationally. The establishment of a foreign subsidiary may prove to be the optimal strategy for your rapidly expanding global operations.
Having a foreign subsidiary allows a company to have a stronger presence in a foreign market and to legally hire locals as employees rather than independent contractors. In this article, we’ll discuss what exactly a foreign subsidiary is, how they function, the pros and cons of establishing one and who should consider doing so to fulfil their global expansion goals.
What is a foreign subsidiary?
Traditionally when a company wishes to start doing business abroad, it needs to open what is called a “foreign subsidiary” within that country overseas. Sometimes referred to as a “local entity”, these companies operate independently from their parent company and are considered separate legal entities under the laws of most countries, and thus are subject to the labour and tax laws of where the foreign subsidiary operates.
Companies tend to also establish foreign subsidiaries in order to boost business, diversify assets and gain certain tax advantages. Since foreign subsidiaries are considered their own entities, they are also legally responsible for their own assets and liabilities, such as tax.
How do foreign subsidiaries work?
As mentioned in the previous section, a company’s foreign subsidiary is considered a completely separate entity from the parent company in the eyes of both the laws governing the parent company and those of where the foreign entity is based. However, depending on the percentage of the foreign subsidiary that is owned by the parent company, there are different legal designations:
- An entity is only deemed a foreign subsidiary if the parent company holds at least 50% of the subsidiary’s stock.
- Owning less than 50% of the stock, the entity is then designated as either an affiliate company or an associate company.
- The entity will be considered a wholly owned subsidiary if the parent company owns 100% of its stock.
The parent company, regardless of its controlling interest, is still able to control the top-level makeup of the foreign subsidiary, which includes board members. However, in the case of the entity that is deemed a “foreign subsidiary” or an “affiliate/associate company”, the decisions have to be made alongside any relevant stakeholders.
Advantages of having a foreign subsidiary
The establishment of a new subsidiary in a different territory comes with a variety of beneficial outcomes. In addition to the possibility of reaching new and lucrative business opportunities, globalization also presents a number of tax advantages and opportunities for business growth. Establishing new subsidiaries in other countries can be quite profitable for your company if it is done at the appropriate time throughout the process of expanding internationally. Several of these benefits include:
1. Access to new markets
A parent company has the opportunity to introduce its goods or services to new and potentially lucrative markets around the world by establishing a foreign subsidiary, which couldn’t be possible otherwise. Establishing a presence in another country through the establishment of a subsidiary might provide improved access to local resources, assets, and grants. It may also be beneficial from a tax perspective, given that your subsidiary will be responsible for paying its own corporate taxes apart from the parent business.
2. Protects parent company
A foreign subsidiary is considered to be a distinct legal entity from its parent firm, in contrast to a representative office or branch location of the parent company. Even while the parent company retains some control over the operations of its subsidiary, the subsidiary is typically protected from the parent company's liability and risk. On the reverse, the parent company also enjoys limited liability for any foreign subsidiary that it establishes.
3. Generates trust
Your company's reputation can be bolstered in many countries around the world by establishing a formal commercial presence there, including through the establishment of a foreign subsidiary. Because it conforms with all local regulations and, technically, has been given a “stamp of approval”, local businesses, governments, industries, and customers are likely to take your organisation more seriously because of this compliance.
Local companies have a greater interest in transacting business with a foreign subsidiary that is locally registered and possesses legal and fiscal assets in the nation in which it is conducting commercial activity. This has the potential to boost overall brand credibility and recognition in the market that you are entering.
4. Gain financial benefits
The establishment of a foreign subsidiary might provide you with enhanced access to local resources, grants, and assets. It may also be beneficial from a tax perspective, given that your subsidiary will be responsible for paying its own corporate taxes apart from the parent business.
Additionally, the foreign subsidiary reaps benefits, most notably in the form of receiving valuable shared resources, such as the parent company's financial systems, technological systems, sales and marketing experience, and vast business opportunities. These resources and opportunities originate directly from the parent company. Because of these resources, the subsidiary is able to immediately kick things into higher gear and compete more effectively in the market.
5. Access global talent pool
By establishing a foreign subsidiary, the parent company gains the ability to hire full-time employees in other countries without having to go through an intermediary. Many countries outside of the United States and the United Kingdom, particularly those in Asia, offer excellent access to cutting-edge technology as well as fresh perspectives on how to approach different technological challenges. A multinational corporation's ability to assemble a genuinely international workforce is facilitated by establishing foreign subsidiaries.
Disadvantages of having a foreign subsidiary
You should be aware that creating overseas subsidiaries is not a straightforward process, despite the fact that doing so may be beneficial to your overall strategy for global expansion. To make it a success, you will need to first conquer a number of significant obstacles, some of which may immediately discourage you from continuing with it. The following are some of the most significant drawbacks associated with creating a foreign subsidiary:
1. Expensive & time consuming
Starting up a foreign subsidiary requires a significant initial commitment, not just monetarily but also in terms of time and other resources. In addition to high initial and ongoing costs, your team, including senior management, will need to devote a significant amount of time to the establishment and maintenance of a foreign subsidiary. This time commitment may take away from other operations that could instead generate a high return on investment (ROI).
When establishing a presence in a foreign country, it is not uncommon to be required to have a capital investment of several hundred thousand pounds and a timetable that can last anywhere from six to nine months. The overall expenditures associated with this endeavour vary from country to country. In addition, the legal regulations of some countries require parent firms to deploy staff members to the location of the subsidiary in order to sign documents and attend certain meetings. This adds more time and money to the overall process.
2. Difficult to dissolve
Putting an end to operations at a foreign subsidiary might be a challenging task in the event that a market fails to perform as anticipated. In certain states and countries, the process of winding down a subsidiary might take just as long, if not longer, than the initial formation of the subsidiary — and it could be just as expensive. You will need to think about things like closing bank accounts, terminating office leases, selling investments, providing enough notice to employees, and a great deal more.
3. Requires local expertise
In some nations, foreign investment or ownership in particular sectors is strictly regulated. In certain cases, such as that in the United Arab Emirates, foreigners are not allowed to possess a share of a company at all, while in others, locals must hold the majority of shares, but a foreign entity can own up to a specified percentage. There are also laws in certain countries which state that a certain number of locals must be hired before being legally allowed to source foreign talent.
It is issues like these that call for the very real need for experts on local labour and tax laws to help you with your global expansion goals. Keeping up to date with local laws and ensuring that your subsidiary maintains compliance consistently can be very time-consuming and resource-intensive if you don’t partner with the right people from the get-go. Even if the parent company isn’t liable for its foreign subsidiaries' lack of compliance, it still hurts the overall business as it can lead to heavy fines and even forced closure in certain cases.
4. Cultural differences
In addition to the obvious barriers of language, money, and distance, businesses that expand into international markets face new bureaucratic, political, monetary, and legal challenges. Also, in order to safeguard the company from various compliance concerns, it is necessary to have local knowledge that is well-versed in the particulars of the local requirements. This is another reason why local expertise is crucial, as we’ve mentioned earlier.
If you’re planning on bringing a global workforce into the foreign subsidiary, there will definitely be some instances where cultural differences may be a problem. One such way is the different work ethics of various staff of different backgrounds, or even just between the head of the foreign subsidiary and their employees. It’s difficult to gauge whether the company culture of the parent company can be maintained throughout its foreign subsidiaries for this very reason.
5. Finding the right staff
Recruiting new employees in other countries presents the human resources departments of a parent firm with their own unique set of obstacles. Working in a different nation frequently leads to more difficult immigration requirements. It could be challenging for you or your team to secure a work visa or permission in this country. The approval process may take several weeks, maybe even months, depending on the country of operation and the person’s country of origin.
This is why it’s important to recruit qualified local talent to help you navigate all these complicated issues and provide you with the right workforce for your needs. When running a foreign subsidiary, having insider knowledge of local job advertising, interviews, job offers, benefits, and onboarding processes is not a luxury—it is a requirement due to the fact that hiring procedures and standards vary from nation to country.
Who needs a foreign subsidiary?
Long story short: the answer to who needs a foreign subsidiary is highly dependent on the company’s situation. Overall, a company doesn’t necessarily need to set up a local entity in order to expand internationally. Foreign subsidiaries are but a single way for a business to expand into foreign markets — and it might not actually be the right choice for your company.
Regardless of the size of your business, the decision to open a foreign subsidiary should be weighted against, firstly, the individual need of your company and, secondly, the pros and cons that we described earlier. However, we can confidently say that if your company is of a small to medium size, you should highly consider partnering with a reputable global expansion partner to help you fulfil your global expansion goals.
The decision to launch a foreign subsidiary rests on your company's specific long-term business goals and ambitions. A comprehensive analysis of your company's resources, infrastructure, and management practices will help you determine the ideal international market for your goods and services.
But regardless of your motivations, you should always weigh the risks, as well as investigate the associated costs and paperwork, before establishing a foreign subsidiary. There are alternatives to forming a subsidiary, such as creating a branch office or partnering with an Employer of Record (EOR) or Professional Employer Organization (PEO).