Nowadays, it’s normal for companies to expand beyond their home borders. One common strategy for this is establishing foreign subsidiaries. But what exactly are these subsidiaries, and why are they important?
In this article, we'll demystify foreign subsidiaries, explaining what they are and why companies choose them. We'll use real examples from renowned companies to illustrate the concept. So, let's explore the significance of foreign subsidiaries in international business.
What is a foreign subsidiary?
A foreign subsidiary, often called a daughter company, is a business entity in a foreign country. It is either fully or partially owned by a foreign company from a different country, known as the parent company or holding company. This setup has several key elements:
Separate Legal Entity
Importantly, a foreign subsidiary operates as a distinct legal entity. It adheres to the legal framework and regulations of the host country where it is located.
Ownership Structure
The level of control the parent company exerts over the subsidiary depends on the ownership structure. If the parent company owns more than 50% of the subsidiary's shares, it often holds a controlling interest. A wholly-owned subsidiary is one where the parent company owns 100% of the shares.
Control and Governance
Despite being legally separate, the parent company typically has varying control over the subsidiary. This control aligns with its ownership percentage and may involve influencing decisions and setting policies.
Taxation
Foreign subsidiaries have the responsibility of filing and paying taxes in the country where they operate under local tax laws. However, there are situations where the parent company can consolidate tax returns with the subsidiary, depending on specific ownership criteria.
Liability
The legal separation extends to liability matters. Generally, the liabilities incurred by the subsidiary do not impact the parent company's assets, providing a layer of legal protection.
Operational Autonomy
Foreign subsidiaries typically maintain their own management teams and decision-making processes. This operational autonomy enables them to adapt to local market conditions and comply with local regulatory requirements.
In summary, a foreign subsidiary offers a strategic means for a parent company to expand its global presence while maintaining legal separation. It operates under the host country's legal framework and can provide market access and tax planning advantages. The degree of influence the parent company wields is contingent on its ownership stake, and both entities collaborate to achieve common business objectives.
Why Classifying Foreign Subsidiaries Matters for Your Business
Understanding the classification of foreign subsidiaries for U.S. tax purposes is vital. It helps identify potential tax and reporting risks, which is crucial for effective post-acquisition planning. Incorrect classification can lead to penalties and financial losses.
Additionally, the classification affects income tax implications, potentially leading to overpayments or underpayments. In short, knowing how foreign subsidiaries are classified is essential for informed financial decisions and legal compliance in international business.
How does a foreign subsidiary compare to a branch office?
A branch office is considered an extension of the parent company for tax purposes. This means that the income generated by the branch is combined with the parent company's income when calculating taxes. The advantage here is that it can help prevent double taxation, where the same income is taxed in both the branch's and the parent company's home countries.
Conversely, a subsidiary is viewed as a separate legal entity. It operates independently and is responsible for its own tax obligations in the host country, following that country's local tax laws and regulations. This can be more complex but may offer tax planning opportunities and potentially favorable tax rates in the host country.
In the case of a foreign branch, the parent company exercises direct control and management over the branch. The parent company makes decisions, sets policies, and oversees the branch's daily operations. This hierarchical structure ensures uniformity in operations across different locations.
On the other hand, a subsidiary enjoys a greater degree of autonomy. It has its own management team, board of directors, and decision-making processes. While it remains accountable to the parent company's overall strategy and goals, it can adapt flexibly to local market conditions and regulations.
In the context of a foreign branch, the parent company assumes all legal liabilities. Since the branch is seen as an extension of the parent company, any legal problems or liabilities incurred by the branch typically affect its assets, potentially putting them at risk.
In contrast, a subsidiary maintains its own legal identity. This means that liabilities incurred by the subsidiary generally do not affect the parent company's assets. The parent company's exposure to risk is limited, providing a level of legal protection.
In summary, choosing between a foreign branch and a subsidiary has implications for taxation, governance, and liability, and businesses must consider these factors when expanding internationally.
How does a foreign subsidiary compare to a permanent establishment or parent company?
A permanent establishment is a specific business status with substantial implications for foreign companies operating in another country. This status typically applies to businesses with a fixed and continuous presence within the host country and often act as parent company representatives. The outcomes of achieving permanent establishment status can vary depending on the specific jurisdiction, but a common consequence is the obligation to pay local taxes. This includes income tax, sales tax, value-added tax (VAT), and other taxes the host country mandates.
In contrast, a subsidiary functions as an independent legal entity and is typically fully owned by its parent company. Despite being under the parent company's ownership, the subsidiary maintains its distinct legal identity. As a result, it adheres to the tax regulations and laws of the country where it operates, which may differ from those in the parent company's home country. From a tax perspective, the subsidiary follows the tax regulations of the host country and is responsible for paying taxes there, including the preparation and submission of tax returns according to local requirements.
Now, let's take a closer look at an affiliate company. If a parent company owns less than 50% of the foreign entity, it's commonly referred to as an affiliate company. The company that owns the foreign entity is called the parent company. It's important to note that even though a parent company can own 100% of the daughter company, they are not a single entity.
In summary, the fundamental distinction between a permanent establishment and a subsidiary lies in how they navigate tax responsibilities and operational autonomy. A permanent establishment often triggers tax obligations and specific criteria, while a subsidiary operates independently, complying with the tax regulations of the host country. This understanding is crucial for companies engaged in international business, as it significantly influences their compliance with tax laws and regulatory requirements in various jurisdictions.
What are the advantages of establishing a foreign subsidiary?
Establishing a foreign subsidiary offers a range of advantages for businesses looking to expand globally:
Helps You Build a Stronger Reputation
Companies that establish local subsidiaries tend to gain greater credibility in their target markets. Local businesses and governments often view foreign subsidiaries registered within their borders more favorably, perceiving them as committed entities with legal and financial ties to the local community.
Opens you up to Opportunities
A foreign subsidiary is like a gateway to new global markets, enabling the parent company to hire local employees directly and avoid intermediaries like an employer of record services. It also creates opportunities for foreign direct investment, where companies bring valuable expertise and skills to attract investments from abroad, fostering international collaboration.
Boosts Efficiency
Subsidiaries play a vital role in handling the increasing workload of a growing company. They divide tasks among different daughter companies, enabling local and foreign employees to concentrate on specific responsibilities, ultimately streamlining the overall operations.
Less Risk, More Control
Parent companies benefit from limited liability concerning the actions of their foreign subsidiaries. This implies that the parent company takes on fewer financial risks while maintaining significant control.
What are the disadvantages of establishing a foreign subsidiary?
While the benefits of foreign subsidiaries are substantial, there are certain challenges and drawbacks to consider:
Eats up Time and Money
Starting a foreign subsidiary is a demanding process. It involves thorough planning, research, and substantial financial investments. This can be especially challenging for companies looking to expand into multiple foreign markets concurrently.
Dealing with Time Zones and Holidays
When operating globally, adjusting to different business cultures and work schedules is important. Managing local employees can sometimes result in conflicts over work hours and holidays. To overcome these challenges, good planning and flexibility are key.
More Red Tape
In the international business arena, decision-making can get complicated. It often involves multiple layers of management in both the parent and subsidiary companies. Also, dealing with different international tax laws and regulations can be tricky, requiring legal expertise to ensure compliance.
These factors contribute to prolonged decision-making processes and increased participation from various stakeholders. Both the parent and subsidiary companies may need to engage legal teams to navigate differing legislations in their respective countries of operation.
Your Ultimate Foreign Subsidiary Example List
To understand what a foreign subsidiary is, it can be helpful to have foreign subsidiary examples to look at. Take a look at these examples to put a face to the name.
Unilever
You may recognize them for popular products like Dove soap and Lipton tea. Unilever operates subsidiaries across the globe.
Nissan
This renowned Japanese automotive company has established subsidiaries in various regions, such as North America and Europe, to manufacture and market their vehicles within those areas.
Procter & Gamble (P&G)
P&G manufactures products like Gillette razors and Tide laundry detergent. They maintain subsidiaries in numerous countries responsible for handling these products locally.
Siemens
Siemens is a major technology corporation with subsidiaries spread across the world. Each subsidiary specializes in distinct sectors, such as energy or healthcare.
HSBC
HSBC is a major bank with branches worldwide. They operate subsidiaries in numerous countries, functioning as local banks while being part of the larger HSBC group.
Novartis
This is a global pharmaceutical company with subsidiaries worldwide. These subsidiaries work on developing new medicines and selling them in their own countries.
Volkswagen Group
Volkswagen owns brands like Audi, Porsche, and Lamborghini. Each of these operates as a separate subsidiary focusing on different types of cars.
Sony Pictures Entertainment
Sony Pictures specializes in producing movies and TV shows. They have subsidiaries all over the world involved in making and distributing entertainment.
7-Eleven
This is a well-known convenience store chain in the United States. After a Japanese company bought a big part of it, 7-Eleven became a subsidiary of that Japanese company.
You're probably familiar with Google. They have subsidiaries in different countries to handle their business locally, especially regarding things like taxes and regulations.
Barrick Gold Corporation
Lastly, we have an example of a Canadian-owned foreign subsidiary. Barrick Gold Corporation operates as a Canadian-owned foreign subsidiary, with gold mining operations in Nevada, USA, fully controlled by its Canadian parent company.
These examples show how foreign subsidiaries help companies expand and do business worldwide, making connecting with local customers and navigating different rules and customs easier.
When Should You Consider Launching a Foreign Subsidiary?
Setting up a foreign subsidiary is a significant move for companies, and knowing when it makes sense is essential. Here are five situations when setting up a foreign subsidiary is a smart choice:
To Strengthen Your Local Presence
Opening a foreign subsidiary shows your commitment to a particular area or foreign country. This foreign investment can help to build relationships with local authorities and businesses, enhancing your reputation.
Setting up a foreign subsidiary can also help access local funding and benefit from regional economic connections.
When Employees Prefer Full-Time Roles
If your employees want the benefits and stability of full-time employment, a subsidiary is a solution. It allows you to provide full-time status, simplifying taxes and offering peace of mind to your workers.
When You Have a Concentrated Workforce
If you already have several employees in a foreign country or specific location, creating a subsidiary can be more efficient than starting from scratch. It ensures a ready workforce, which can significantly speed up the subsidiary's development.
To Minimize Financial Risk
Subsidiaries are separate legal entities from their parent companies. This separation means that the parent company's financial risk is limited if the subsidiary faces legal issues or fines. Additionally, it provides an exit strategy if the subsidiary's performance disappoints.
To Lower Tax Rates
Foreign subsidiaries enjoy lower tax rates than their parent companies in their home countries. They typically pay taxes based only on revenue generated in the host country, leading to substantial tax advantages.
Connect with Borderless
Opening a foreign subsidiary or moving forward with a global expansion doesn’t make sense for every organization. So, it’s important to assess the risks, costs, and paperwork involved. If a subsidiary doesn't align with your goals, explore alternative options like Employer of Record (EOR) services, such as Borderless.
Get in touch with Borderless today to discover the best strategy for your international expansion. We’ll offer expert guidance and tailored solutions to simplify your global business endeavors. Let us help you navigate the complexities of international expansion.
