A foreign subsidiary is a company owned or controlled by a parent company based in another country. This subsidiary operates under the laws of the foreign country where it is located while aligning with the objectives of its parent company.
Example of a foreign subsidiary
A foreign subsidiary can be set up as a partially-owned or wholly-owned subsidiary. The more common structure is a wholly-owned subsidiary, where a parent company fully owns and controls the subsidiary company operating in another country.
For example, a US-based corporation might establish a wholly-owned subsidiary in Canada to handle Canadian sales, complying with Canadian regulations and meeting local demand, while maintaining full control over the subsidiary's operations and financial activities.
Foreign subsidiary vs. foreign branch
A foreign subsidiary differs from a branch office in that a subsidiary is a legally separate entity from its parent company, while a branch office is an extension of the parent company itself.
This means that a subsidiary must follow the legal regulations of the home country where it’s located, whereas a branch office remains under the legal structure of the parent company's home country. This structural difference often results in different tax and regulatory obligations, but this can vary depending on the countries involved.
Foreign subsidiary vs. permanent establishment
A foreign subsidiary is established as a distinct entity within a host country, operating independently under local laws. In contrast, a permanent establishment is not necessarily a separate legal entity, but rather a business presence that may trigger local tax obligations due to ongoing business activities in the host country.
Why would you establish a foreign subsidiary?
Establishing a foreign subsidiary allows a company to create a separate legal entity that can engage in local business operations under the regulatory framework of a different country. This can provide strategic advantages for international business growth.
To expand into a new market
A foreign subsidiary can be a core part of a company’s global expansion strategy, allowing for more effective international expansion. Setting up operations in a new country allows a business to establish its brand locally, interact directly with customers, and respond to market demands in real time.
To hire employees in a foreign country
For companies looking to build a global workforce, a foreign subsidiary facilitates the direct hiring of employees in a different country. Generally, companies have limited legal avenues for hiring employees in foreign countries, and establishing a foreign entity is one of them. Doing so enables compliance with local labor laws and policies governing global employment, as well as smoother integration with the local culture and market.
For local tax benefits
Foreign subsidiaries are often created as a holding company or other foreign company structure to take advantage of local corporate tax benefits. Many countries offer incentives, such as reduced income tax or favorable tax laws for foreign businesses. This setup may allow a company’s foreign subsidiary to streamline its tax obligations; for example, allowing the subsidiary to save money on a local tax return that complies with the host country’s tax requirements.
To shield your parent company from risk
One of the key advantages of a foreign subsidiary is the limited liability it provides to the parent company. Since the subsidiary is a distinct business entity, any potential legal or financial liabilities are contained within the local operation. This separation offers a buffer against legal issues, allowing for compliance with local authorities without directly affecting the parent company’s assets.
Pros and cons of setting up a foreign subsidiary
Pros of setting up a foreign subsidiary
Cons of setting up a foreign subsidiary
Direct access to the target market: A foreign subsidiary allows companies to operate closer to their target market, enabling more effective marketing and customer engagement.
Cultural differences: Navigating cultural differences and local business practices can be challenging and may require adapting business strategies to align with local expectations.
Separate entity structure: As a separate entity, a subsidiary helps limit liability, shielding the parent company from direct financial or legal risks associated with the subsidiary’s operations.
Complex regulations: Foreign subsidiaries are subject to local foreign investment laws and regulations, which can be complex and may differ significantly from those in the parent company’s country.
Better market reach: Setting up a subsidiary facilitates access to the foreign market, creating opportunities to expand and grow business presence internationally.
Higher operational costs: Running a foreign subsidiary often entails substantial costs for staffing, facilities, and compliance with local employment laws and tax regulations.
Stronger relationships with local businesses: Establishing a subsidiary can foster partnerships and credibility with local businesses, suppliers, and other stakeholders in the region.
Management challenges: Operating as a separate entity may create distance from the parent company, making effective management and alignment more challenging.
Foreign investment incentives: Many countries provide tax incentives to attract foreign investment, helping to reduce operational costs for subsidiaries.
Time-consuming setup: The setup process for a foreign subsidiary, including registration, permits, and infrastructure, can be time-consuming and require extensive preparation.
Alternatives to establishing a foreign subsidiary
For companies exploring international business but not ready to set up a full foreign subsidiary, there are alternative approaches, such as forming an affiliate company or partnering with a local entity. These options can provide a foothold in the foreign market with less commitment. Other alternatives include:
Partnering with an Employer of Record (EOR)
A popular alternative to establishing a foreign subsidiary is partnering with an Employer of Record (EOR). EORs handle many human resources functions on their client companies’ behalf, including employee onboarding, payroll management, employee benefits administration, compliance, and other administrative tasks. They can also offer local expertise to help bridge the gap for businesses expanding into new markets where they’re unfamiliar with local laws and customs.
Hiring contractors
Another option for expanding global business operations without establishing a subsidiary is hiring contractors instead of full-time employees. By forming partnerships with independent contractors, businesses can quickly bring on talent in a foreign market. This approach enables companies to test market viability with minimal risk and fewer compliance requirements, though it may not offer the same level of control and long-term integration as hiring employees directly.
Frequently asked questions about foreign subsidiaries
How do you set up a foreign subsidiary?
Setting up a foreign subsidiary requires careful planning and organization. The process typically involves several key steps, starting with opening a bank account in the host country, appointing a board of directors and a local management team, and registering the business as a legal entity in the host country, which may require various permits, legal filings, and coordination with local authorities.
Is setting up a foreign subsidiary risky?
Setting up a foreign subsidiary does carry certain risks. These can include navigating complex regulatory requirements, facing potential cultural differences, and managing local compliance with employment and tax laws. There can also be financial risks, as establishing a subsidiary may involve high initial costs and ongoing expenses.
How do you know if setting up a foreign subsidiary is right for your business?
Deciding whether a foreign subsidiary is the right step for your business depends on factors like market demand, the potential for long-term growth, and the level of control you seek over local operations. Businesses that aim for a global expansion strategy and seek a stable, lasting presence in a new country often benefit from establishing a subsidiary. However, if the goals are more short-term or the regulatory environment is highly complex, other options like hiring through an EOR or working with local partners may be more appropriate. Consider consulting with local experts and evaluating the financial and operational demands before making a final decision.
Rippling and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any related activities or transactions.