One option when expanding to new countries is to set up a foreign subsidiary. This option provides numerous advantages, including being able to take advantage of local opportunities and participate in more business activities. However, there are also significant disadvantages in setting up a foreign subsidiary.
Understanding the pros and cons of setting up a foreign subsidiary is important so that you can make an informed decision about whether to establish the subsidiary, or to use an alternative, such as a global Professional Employer Organization or ‘global PEO‘.
What Is a Foreign Subsidiary?
A foreign subsidiary is a company that is majority owned or controlled by a company in another country.
Subsidiaries are sometimes called ‘daughter companies’, and the companies that own or control them are often called ‘parent companies’. Where a parent company does nothing except hold shares in a subsidiary company or companies it is known as a ‘holding company’. Collectively, theses related companies are sometimes known as a ‘corporate group’.
The exact definition of a subsidiary depends on the law of the country in which it is incorporated. But generally speaking, a subsidiary exists where the parent company has the majority of shareholder or member voting rights in a company.
Where the parent or holding company owns 100 percent of the subsidiary it is known as a ‘wholly-owned subsidiary’.
Foreign subsidiaries can be set up from scratch in a new international location, or they may involve merger with, or acquisition of, an existing company in the foreign location.
A subsidiary can be distinguished from a branch of an international enterprise, which has no distinct legal personality in the jurisdiction of expansion.
Some famous examples of foreign subsidiaries include:
- RJ Reynolds Tobacco. This collection of subsidiaries, incorporated in the United States, manufacture popular cigarette brands including Camel and Pall Mall. As a result of a 2017 acquisition, they are now ultimately owned and controlled by British American Tobacco, headquartered in London, UK.
- Rowntree’s. This UK subsidiary is an acquisition of Swiss confectionary conglomerate Nestle S.A., and manufactures popular UK confectionary such as Fruit Pastilles and Fruit Gums.
- Marc Jacobs. Marc Jacobs International, LLC, popular US clothing brand, is a foreign subsidiary of the French luxury goods conglomerate, LVMH Moët Hennessy Louis Vuitton (LVMH), headquartered in Paris.
Advantages of Setting Up a Foreign Subsidiary
Some of the major advantages of setting up a foreign subsidiary include:
Access to New Markets for Your Products and Services
Setting up a foreign subsidiary establishes a legal entity in another country. Legal entities can market their products and services to the local population. They can also import and export goods.
Additionally, companies with a local presence can expand their brand recognition to new markets so that they can potentially increase their profits.
Foreign countries present enormous opportunities for growth, and even some of the lesser known ‘middle economies’ provide viable markets for business expansion.
More Affordable Options for Manufacturing
In certain markets, setting up a foreign subsidiary can give you access to lower costs for goods and labor.
Many overseas markets also have a highly developed manufacturing infrastructure that enables not only lower materials costs, but lower costs to produce goods in bulk, which of course can help you minimize overall production costs.
Access to Technical Skills
Many foreign countries — increasingly in Asia — provide great access to advanced technology and new ways of thinking about technical issues. For example, Japan offers a high level of technical knowledge that continues to attract foreign investment. Through foreign subsidiaries, international business can recruit a truly global team.
Using a foreign subsidiary may also make it more straightforward to issue equity compensation to foreign employees. Read more at The Ultimate Guide to Granting Stock Options to Foreign Employees.
Access to Local Knowledge
By establishing a legal entity in a foreign country, a business can make new business relationships with local partners and set up joint ventures that take advantage of localized knowledge.
Increased Expansion Opportunities
In some situations, entering a new country can support enhanced business growth, and increased revenue, that would not have been possible in the home country, especially when the domestic market is flooded with competition.
Streamlined Processes and Incentives
Some countries openly welcome foreign investment and make the process to incorporate a company simple. They may even provide incentives to encourage foreign investment, such as:
- Tax incentives
- No minimum capital requirement
- Special economic zones
- Free trade zones
- Faster incorporation processes
- No or few restrictions on foreign ownership of companies
Disadvantages of Setting Up a Foreign Subsidiary
Some of the most notable disadvantages of setting up a foreign subsidiary include:
Increased Cost and Time
Setting up a foreign subsidiary can often take significant time and money, which often bars many foreign companies from making this investment.
The paid-up capital requirement varies by country and industry, but sometimes it is quite substantial. For example, in Singapore, the paid-up capital requirement for an insurance intermediary firm is $300,000, and the same is $100,000 for travel agencies.
Prohibitions on Foreign Ownership
Some countries regulate certain industries and prohibit foreign ownership. In some situations, no foreign ownership is permitted while in others, ownership must primarily be local but a foreigner can invest a certain percentage into the business.
Some countries have been historically reluctant for companies to be wholly foreign-owned. For example, the United Arab Emirates required a foreign investor to have a local partner with at least 51% ownership stake before setting up a foreign subsidiary until the law was changed in 2019.
There are still certain industries in the UAE that limit the presence of foreign workers.
Complicated Immigration Requirements
Working in a foreign country often results in complicated immigration requirements. It may be difficult to obtain a work visa or permit for you or your staff. It may take several weeks for approval.
Visas may only provide for short stays, and often there are limited on what business activities can be undertaken.
Complex Compliance Requirements
One of the biggest challenges to setting up a foreign subsidiary is doing so in a compliant manner. There are often very complex rules related to hiring staff, managing payroll, complying with tax requirements, and declaring the activities of your business.
What Are the Alternatives to Setting Up a Foreign Subsidiary?
After weighing up the pros and cons of establishing a foreign subsidiary, a business may decide that it makes more sense to go with an alternative. So what are the alternatives to setting up a foreign subsidiary? While the alternatives available do differ depending on the country in question, we consider some of the popular alternatives that are often available:
In a foreign affiliate, the foreign enterprise only has a minority, rather than a majority, stake in the overseas enterprise.
This can be a beneficial form of foreign investment as it may better manage reputational risk (this form of investment is less ‘visible’ than a foreign subsidiary), and limits financial risk by involving a smaller stake in the foreign enterprise.
On the other hand, investing in a foreign affiliate will not allow the same degree of control as a foreign subsidiary, and can have tax disadvantages (e.g., losses in one affiliate usually cannot be offset against profits in another to decrease the overall tax burden of the group).
Instead of setting up a foreign subsidiary, some businesses may decide to engage one or more independent contractors based overseas. In such an arrangement, individual contracts would be signed with each independent contractor establishing their obligations to the company.
Disadvantages of this approach include:
- Unenforceability of contractual terms. Without a legal presence in a foreign country, it is generally much more difficult (and expensive) to attempt to enforce those terms in the legal system of that country.
- Potential employee misclassification. If the relationship between the independent contractors and the hiring company is interpreted by the tax authorities as one of employment, significant back-taxes and penalties could apply. Read more about this issue at What’s the Difference between Employees and Independent Contractors?
- Tax uncertainty. The presence of independent contractors, depending on the circumstances, can create a ‘dependent agent permanent establishment’, which can result in corporate tax liability. Read more about this at What is Permanent Establishment and Why Does It Matter?
In a partnership, individuals join together to run an enterprise (whether domestically or internationally), and under the terms of a partnership agreement, those individuals take on certain obligations and agree to share in the assets, profits and liabilities of the enterprise. In a general partnership, the parties are jointly and severally liable for the debts of the enterprise.
Note, in some countries there are limitations on foreign individuals being part of a partnership (see for example, India’s Partnership Act 1932).
In some countries it is possible to set up a limited partnership, or limited liability partnership (LLP) which limits the liability of participants for each other’s debts, and may allow for foreign participation.
A joint venture involves two distinct businesses (one of which may be foreign) joining together for a distinct business project or enterprise in another country. This could involve setting up a separate company as a vehicle for that joint venture: Where the foreign company has majority ownership in that joint venture company, this will be a foreign subsidiary.
Where there is no subsidiary established, the enterprise is known as an unincorporated joint venture and obligations and profit sharing will be governed almost entirely by a written joint venture agreement.
A joint venture allows the pooling of resources of several parties, reducing the need for large capital contributions and placing limits on the liability of participants.
A foreign trust (sometimes called an ‘offshore trust’) is a trust set up overseas by an individual (the settlor) who is not resident there.
The rules for foreign trusts depend on (a), the location of the settlor/grantor (b), the location of the beneficiaries and (c), the location of the trust itself (where the trustees are based and what determines the law that governs the trust).
Foreign trusts are commonly used as a form of international tax management and asset protection. But it is also possible to carry on an overseas business through a foreign trust structure.
For example, trading trusts are an extremely common business form in Australia and New Zealand which can have significant tax advantages.
Businesses using foreign trusts should be aware that this can have significant tax consequences in their country of residence (see, for example, the IRS reporting requirements for US taxpayers).
Global PEO solution
A global PEO solution means using a specialist global expansion firm to employ staff in a foreign location. This can be a more cost-effective international expansion solution than setting up a foreign subsidiary. We discuss this possibility in further detail below.
Should You Set Up a Foreign Subsidiary?
As discussed above, setting up a foreign subsidiary entails many advantages and disadvantages. The pros and cons of this option need to be weighed up against the pros and cons of the alternatives to a foreign subsidiary set out above.
Businesses that plan to have a long-term presence in the country often opt to set up a foreign subsidiary because the benefits often outweigh the risks.
In these situations, the time and expense of setting up a foreign subsidiary can often be justified by the greater flexibility that having a separate legal entity provides.
However, in other situations, alternatives to setting up a separate legal entity are a better fit for the company. Using a PEO is often a better alternative to companies that:
- Want to test the market before investing heavily in the country
- Do not want to invest large paid-up capital into a foreign country
- Want to take advantage of opportunities right now
- Do not want to wait for the competition of the lengthy incorporation process
- Want the flexibility to hire and terminate staff as their business needs dictate
PEOs already have the necessary legal structure in place to handle all employment, payroll, and immigration matters.
It also has the expertise – often in-house – to ensure full compliance with all foreign laws and regulations. For many companies, a PEO is a cost-effective, fast, and reliable alternative to setting up a foreign subsidiary.
Working with Horizons
Horizons is your global partner who can help you realize your global expansion objectives. Our staff consists of tax, legal, HR, and employment experts who are experienced in various industries.
We can provide you with compliant legal contracts, set up your payroll process, and assist you with compliance matters. With our PEO and Employer of Record services, you transfer the risks of employer liability to us while you benefit from staff who are quickly deployed to your chosen country.
If you decide to incorporate a company overseas, and set up a foreign subsidiary, we can help you carry out this process, thus providing you with short- and long-term legal and employment solutions for your new country of operations.
Contact us today to get started on your global expansion.