International expansion can help organizations to drive a lot of revenue and growth. However, entering an overseas market involves a lot of challenges.
The very first question here is – how to initiate international business operations in a new country.
Many organizations opt for the foreign subsidiary option. However, there are more choices left to businesses.
Here is a complete guide to help entrepreneurs understand more about overseas subsidiaries and make informed decisions on whether or not it is a viable option.
So, let’s get started.
What is a Foreign Subsidiary?
A foreign subsidiary is a business unit operating in the international market. A subsidiary is a part of a large enterprise (parent company) headquartered in another country. Large organizations acquire or open foreign subsidiaries to build their presence in a new market, boost global revenue, and experience tax benefits.
The type of a foreign subsidiary depends on the percentage of the stake held by the parent company. Foreign companies can be segregated into the following three categories:
- When the parent company’s stake is less than 50% in a foreign company, it is called an affiliate.
- When a parent company holds 100% shares of the subsidiary, it is known as a wholly owned subsidiary.
- When the parent company holds more than 50% of the stock in the foreign company, it is called a regular subsidiary.
A foreign subsidiary operates independently and efficiently manages its assets and liabilities. For instance, if the parent company is headquartered in the U.S. and the subsidiary resides in Italy, U.S. laws won’t be applicable, and the subsidiary has to comply with the host country’s tax regulations, Italy.
However, the foreign company has some control over the actions of the overseas subsidiary. These include:
- Establishing the board of directors of the subsidiary
- Build a subsidiary independently without shareholders’ votes
- Sell a subsidiary without shareholders’ approval
Do you Need a Foreign Subsidiary for Global Expansion?
No, investing in a foreign subsidiary is not mandatory to expand a business overseas. It is one of the global business expansion techniques to enter a new market. Hence, before making a decision on such kind of investment, ensure that it is the right fit for you.
Here are the pros and cons of investing in a global subsidiary. Make sure to take these into consideration:
Pros
- Investing in a foreign subsidiary can result in huge tax benefits for the foreign company. When a parent company invests in multiple global subsidiaries, the losses can be adjusted against the profit made from the subsidiaries.
- Investing in a subsidiary is not risk-focused. A subsidiary operates independently from the parent company. Hence, the subsidiary’s losses cannot be transferred to the parent company. However, the foreign company might be subject to some obligations if the subsidiary goes bankrupt.
- Collaborating with a foreign subsidiary can create new diversification opportunities for the parent company and increase the efficiency of operations.
Cons
- If the parent company does not entirely own the subsidiary, there can be occasional management and control issues. Such situations can result in delays in decision-making.
- The cost can be a concerning factor if you are a new company. The legal cost involved in establishing a subsidiary is pretty high, along with the tax filing requirements.
Investing in a foreign subsidiary might not be the best option if you are a startup just beginning your international expansion journey in a new market. Initially, you should focus on strengthening your financial base to survive in the market for a long.
On the contrary, investing in a subsidiary can bring a lot of diversification and profit gain opportunities if you have a growing business with a significant financial and legal footprint.
How does a Foreign Subsidiary Work?
A foreign subsidiary is the financial asset of the parent company. The finances of the foreign subsidiary are reflected in the parent company’s balance sheet. A subsidiary may use different bank accounts in another country, different from the parent company.
A foreign subsidiary is not subject to tax, even if the subsidiary is wholly owned. The subsidiary strictly files taxes as per the legislation of the host country.
A parent company doesn’t need to establish its branch in the host country unless the host country’s legislations demand it. The branch of the overseas subsidiary is sufficient.
Examples of Foreign Subsidiary Companies
Popular social media brand Instagram is a subsidiary of Facebook (Known as Meta since 2021). Facebook acquired Instagram in 2012, and it is a wholly-owned subsidiary, with Facebook holding 100% of the stakes. However, Instagram operates independently from Facebook.
There are several other examples of foreign subsidiaries in the food industry too. For instance, Yum! Brands are the parent company of KFC, Pizza Hut, and Taco Bell.
What are the Alternatives to Setting up a Foreign Subsidiary?
By now, you know the advantages and disadvantages of establishing an overseas subsidiary. Establishing a foreign subsidiary is not mandatory, and if you are wondering what the alternatives are, here are a few:
Foreign affiliates
One of the major alternatives to establishing a foreign subsidiary is a foreign affiliate. In an affiliate, the parent company holds up to 50% stake in the affiliate. Affiliates are a major type of international investment. Strategic affiliate investment can help businesses improve their brand image in a new market.
However, the degree of control is minimal in the case of a foreign subsidiary. However, tax advantages can be applicable.
Partnerships
A partnership is where two or more individuals collaborate in an international market to run an enterprise. These individuals sign a partnership agreement where each of them is subject to certain obligations. They usually share both the profit and debts of the enterprise.
Different countries have different types of liability laws. For instance, some countries can establish limited liability regulations where the liabilities of the partners are limited.
Independent contractors
Sometimes, the alternative to spending in a subsidiary is collaborating with a few independent contractors operating in the overseas market. It will be a type of international business agreement where each contractor will sign a specific agreement to establish the company’s obligations.
However, this arrangement has certain disadvantages. These include:
- The presence of multiple independent contractors can result in tax uncertainty. It may result in a tax liability for the parent company.
- The relationship between a parent company and the independent contractor should be defined efficiently in the independent contractor agreement. Else, it may result in tax penalties.
- Suppose the parent company is not legally present in the host country. In that case, it can be complicated and costly to enforce the legislation of the host country into the parent company’s legal framework.
Joint venture
When two distinct organizations collaborate to build a new legal entity, this new enterprise is called a joint venture. It can mean establishing a new legal enterprise where the foreign company has majorities of the stake. In that case, the joint venture will be the foreign subsidiary of the parent company.
On the contrary, when no subsidiary is established, the joint venture will have a distinct legal agreement. A joint venture is responsible for utilizing resources and capital from different sources.
Global PEO solution
A global Professional Employer Organization (PEO) solution is related to offering reliable support to international entrepreneurs in onboarding new employees, managing their payrolls, and offering them the appropriate benefits and expenses.
Sometimes, outsourcing can be a much more cost-effective alternative to the subsidiary.
A great example of a global PEO solution is – Multiplier. It is a B2B SaaS solution that helps international businesses to:
- Set up your multi-currency payroll in minutes and make payments to freelancers and employees without any challenges.
- Provide competitive benefits to the employees seamlessly. You can also offer personalized insurance policies to the employees to ensure a smooth experience.
- Manage a unified dashboard to track all employee documentation and contracts. Access these documents whenever you are in need.
To know further, sign up for a free demo!
Final Words
Investing in a foreign subsidiary ultimately depends on your business type. If you are an early-stage startup planning to build a presence in an international market, investing in a foreign subsidiary may not be the best option. It can be highly expensive and restrict your chances of scaling.
Alternatively, a foreign subsidiary can be a great choice if you are an established brand looking for overseas expansion. It will help you gain a competitive edge in the international environment and open doors to several benefits like diversification, growth, and tax advantages.
Also, there is a third solution called PEO, where a business can outsource onboarding facilities from brands like Multiplier. Before making a final decision, make sure to select the option that suits you the best.
