Expanding your business into new markets can be a lucrative opportunity for growth, but there are so many ways to approach it. Setting up foreign subsidiaries is a popular method, but it’s not the best option for all companies or global expansion strategies.
This article will help you weigh up the pros and cons of establishing a foreign subsidiary and identify when (and if) it’s the right option for your company. We also present an alternative for the early stages of international expansion, which can help you minimize risk.
Do You Need a Foreign Subsidiary for Global Expansion?
The short answer is no; you don’t necessarily need to set up a foreign subsidiary to expand your business internationally. It’s just one of many ways to enter a new market, and while it’s certainly the best option for some businesses, it may not be for yours.
If you’re in the early stages of global expansion and you haven’t yet validated a new market, opening a foreign subsidiary probably isn’t the best option for your business. Before setting up shop permanently in a new market, you should test the waters to determine if it has true value and longevity.
During this period, it’s wise to keep your legal and financial footprint as light as possible. This will allow you to easily withdraw from the market if necessary. Hiring a small, local team to conduct market research is an effective way of gathering more intel before establishing permanent roots. And to hire international talent, you don’t even need to set up a local entity - you can use an Employer of Record (EOR) instead.
Once you’ve validated a market and are committed to growing your business there, establishing a local entity could be the next logical step in your expansion process. This local entity could take the form of a foreign subsidiary or a host of other entity types, like a branch office, affiliate company, or partnership.
To determine which option is best for your business, you need to assess your wider global expansion strategy, company objectives, finances, resources, and logistical capabilities. You also need to consider each market’s regulatory limitations when it comes to foreign investment.
What Is a Foreign Subsidiary?
A foreign subsidiary is an overseas company owned or controlled by a larger enterprise based in another country. Foreign subsidiaries are separate legal entities and must comply with the law of the local jurisdiction. They’re also responsible for their own assets and taxes.
How Does a Foreign Subsidiary Work?
To be classed as a foreign subsidiary company, the business entity must be more than 50% owned by a foreign parent company or holding company. If the parent company owns 100% of the shares, this is called a “wholly owned subsidiary.”
The parent company, along with any other shareholders, should elect a board of directors to maintain control over the management and operations of the foreign subsidiary.
If a parent company owns less than 50% of the foreign entity’s shares, it’s designated an associate or affiliate company instead.
Foreign Branch Vs. Foreign Subsidiary
Both foreign branches and foreign subsidiaries can enable businesses to expand internationally, but there is a key difference between them. A subsidiary is legally and fiscally separate from its parent or holding company, whereas a branch office is not.
This means a parent company remains liable for a branch office but isn’t for a subsidiary. You can find out more about branch offices in our separate guide about local entities.
Foreign Subsidiary Vs. Permanent Establishment?
Permanent Establishment (PE) is a concept or state of being rather than an entity type. Tax authorities generally define a Permanent Establishment as a permanent, ongoing, and revenue-generating setup within its jurisdiction. As such, it may be liable to pay corporate taxes in that jurisdiction.
Because of this definition, a foreign subsidiary is by its very nature a PE. However, many other types of entities or business structures may be considered a Permanent Establishment, too, including branch offices and affiliate companies. A business may even create PE by hiring staff abroad without opening a physical office.
If you’d like to understand what triggers PE in more detail, you can read our separate guide on the subject here.
Foreign Subsidiaries & PE Risk
While a foreign subsidiary pays corporate tax separately, the parent company could still be exposed to PE risk if it’s found to be doing business for itself through the foreign subsidiary. In this situation, the parent company may become liable for paying corporate taxes, in addition to potential fines.
Pros of Establishing a Foreign Subsidiary
When executed at the right stage of international expansion, establishing new foreign subsidiaries can be very beneficial for your business.
It Offers Financial Benefits
Opening a foreign subsidiary can give you increased access to local resources, assets, and grants. It can also be advantageous for tax reasons because your subsidiary pays corporate taxes separately from the parent company.
It Protects Your Parent Company
Unlike a representative or branch office, a foreign subsidiary is treated as a separate legal entity from its parent company. While the parent company still has control over how its subsidiary operates, liability and risk are generally isolated.
It Creates Trust & Credibility
In many countries, having an official business presence like a foreign subsidiary can help generate more credibility for your company. Local businesses, governments, industries, and consumers will likely take your company more seriously because it complies with all local regulations. This can increase overall brand trust and recognition in your new market.
Cons of Establishing a Foreign Subsidiary
While your global expansion strategy may benefit from establishing foreign subsidiaries, you also should know that it’s not a simple process. There are some big challenges you’ll have to overcome to make it a success.
It’s Expensive & Resource-intensive
Foreign subsidiaries require a large investment from the offset, both in terms of money and resources. In addition to expensive setup and running costs, your team - including senior management - will need to dedicate a lot of time to establishing and maintaining a foreign subsidiary, which may detract from other high ROI activities.
Local Expertise Is Required
Navigating cultural, political, legal, tax, and bureaucratic systems in a foreign country is complex. Without seeking (often expensive) local expertise, your global expansion plans have a much higher chance of failure. You also put your business at a greater risk of non-compliance, which could lead to fines and legal action.
It’s Tricky to Dissolve
If your market doesn’t deliver as expected, closing down a foreign subsidiary can be hard work. In some jurisdictions, it can take as long, if not longer, to dissolve a subsidiary than to set one up in the first place. You need to consider closing bank accounts, ending office leases, liquidating investments, giving employees enough notice, and much more.
Weighing up the Pros & Cons
Due to the time, effort, and resources needed to establish (and dissolve) a foreign subsidiary, you need to be confident it’s the right decision before committing to one. Foreign subsidiaries can be beneficial for international expansion, but only once you’ve validated your new markets.
At the beginning of your expansion efforts, it’s best to be as agile as possible, hiring a small but experienced team on the ground. They can help you assess the landscape, conduct further market research, and test the market so you know that it’s worth investing in long term.