A standard practice in global expansion is to establish a new business entity. Global businesses may form a foreign subsidiary to take advantage of local technical skills or participate in regional economic activities.
While the advantages of foreign subsidiaries may help you expand into new markets and niches with minimum liability to the parent company, the disadvantages of foreign subsidiaries may result in increased compliance costs in the foreign country.
A thorough understanding of foreign subsidiary pros and cons will help you decide whether to set up a subsidiary or use an alternative, such as a global Professional Employer Organization or ‘global PEO‘.
Things to Consider Before Setting Up a Foreign Subsidiary
Consider the following criteria before setting up a subsidiary in a foreign land.
Stability of foreign government
The following aspects determine the stability of the local government and its authority when reviewing overseas business options.
- Currency exchange rates
- Immigration and employment laws
- Protection policies for businesses, like intellectual property and trademark protection
- Access to affordable capital
- Government assistance programs for businesses
- Communication and transportation options
It is sensible to seek the services of local consultants over the political and business environment before deciding on any overseas expansion.
Your business requirements
Your business cases need to respond to the challenges, adversity, and rewards of expanding overseas. Some strategies to consider are:
- Perform a market study to understand the consumer personality, economic feasibility, market trends, financial cost patterns, and market forecasts.
- Do a financial feasibility study to determine the costs to set up, run and sustain a foreign subsidiary.
- Partnership and liaison relationship development – seek guidance and opportunity by engaging in a “local” partnership with an existing client or supplier
The legal structure of the subsidiary
When a company decides to register a subsidiary, representatives of the legal and tax departments can determine among common types of entities to choose from –
- Limited Liability Companies (LLCs)
- General Partnerships
- Limited Partnerships (LPs)
- Limited Liability Partnerships (LLPs)
- Representative Offices
- Branch Offices
LLCs are usually the ideal business structure for small businesses as it promises personal liability protection, flexible tax options, management flexibility, less paperwork, and are inexpensive.
Eventually, the management chooses the type of legal entity depending on the purpose of the subsidiary, the composition of its interest holders, local jurisdictional requirements, and tax implications.
Minimum capital, FDI limits, & business visas in foreign countries
After the legal structure of a subsidiary is fixed, parent companies must pay heed to the minimum capital requirement of that particular structure. The minimum capital necessary to form an entity varies by country.
For example, forming a foreign subsidiary in several European jurisdictions requires a fixed capital. Most developing countries in Asia & South America base capitalization on reasonableness, operating costs, or practical considerations.
Before setting up a subsidiary, it is also essential to evaluate the sectors of the economy ready for foreign direct investment (FDI) without any prior approval from the local government. Additionally, consider the business visa requirements for shareholders/directions of subsidiaries in the proposed jurisdiction.
Post-incorporation of a subsidiary
Even after a foreign entity is incorporated, consider additional items like license applications, taxation issues, obtaining payroll and customs numbers, and opening a permanent bank account. Companies also need to take care of the work visas and permits of the foreign employees.
Why Should You Establish a Foreign Subsidiary Company?
Establishing a subsidiary in a foreign country can be beneficial for a company for several reasons like brand image, access to the market, reduced tax liabilities, etc. The advantages of foreign subsidiaries are discussed in the following paragraphs by identifying the pros and cons of establishing a legal entity in specific regions.
Better access to local technical talent in Asia
Some Asian countries, particularly India, Singapore, China, and Japan, have qualified human resources in technical fields and better access to advanced technology.
- Southeast Asia ranks among the most dynamic regions, with a combined gross domestic product of $2.6 trillion covering 630 million consumers.
- Japan & Singapore have a strong history of international business cooperation and a high level of technical knowledge in some industries.
- China & India compete well in offering cost-effective manufacturing and production.
- India is also a leading global hub for IT-enabled industries. The latest population Census declares English as the second-most widely spoken in India.
- There are obvious cultural and language barriers in conducting business in many Asian markets.
- Tax issues and bureaucratic hurdles in the government are complex and hence, must be fully researched.
Taking advantage of free trade zones in UAE
The parent company can establish its foreign subsidiaries in Free Trade Zones without facing extensive barriers to entry.
- The UAE promotes itself as a global business hub and a gateway to the Middle East.
- Various free trade zones in the UAE simplify incorporating a foreign entity into the permitted industries.
- Saudi Arabia is another attractive location for business expansion and investment in the Middle East region.
- Foreign ownership of subsidiary companies is not limited so long as all capital and registration requirements are met.
- The UAE is considered costly for expansion due to high capital investment requirements, licenses, visas, registrations, and real estate values.
- Different free zones have varying capital requirements, business licenses, and costs to set up subsidiaries.
- To establish a foreign subsidiary in the UAE outside free trade zones, a local partner must have a 51% ownership stake.
- Saudi Arabia follows stringent employment laws on termination of workers, employee compensation, and reinstatement.
Enter the most sophisticated markets in the European Union
The interlocked countries and the closely integrated market makes setting up a foreign subsidiary in the European Union highly lucrative.
- The European Union is among the world’s largest and most sophisticated markets.
- All member countries adhere to the same business and immigration rules for a consistent flow of human capital.
- Low-tax countries like Ireland have many U.S. groups based on their European operations.
- Taxation of foreign businesses will differ based on specific jurisdiction and if the business is from a non-EU country.
- Cultural and language differences may arise among different member states, posing a challenge in expansion.
Companies prefer the USA to build brand value
Almost any technology-driven company wants to associate with the USA. Companies form a subsidiary or acquire one in the USA to expand their brand’s reach.
- Needless to say, the USA attracts businesses worldwide and benefits from the free spirit of a capitalist-driven economy.
- The market openness best serves foreign businesses to introduce and build new brands.
- Immigration policies of the USA are stringent, and business visas for foreign workers may require multiple clearances.
- Setting up a subsidiary can be complex as it demands coordinating with different entities at the state, local, and federal levels.
Leveraging local economic opportunities
Any company can use local economic opportunities in a foreign land to build a profitable business out of it.
- Algeria offers excellent opportunities in infrastructure, engineering, construction, and telecommunications.
- Australia & New Zealand have strong potential in dairy products due to the availability of vast pastoral lands.
- Netherlands offers a business-friendly environment with a strong creative industry, IT industry & energy industry.
- Laws are restrictive concerning foreign investments in Algeria.
- Highly restrictive border entry policies pursued by Australia & New Zealand during the recent pandemic may create obstacles to business expansion.
- European nations are bound by stringent consumer protection laws. For instance, the Global Data Protection Regulations (GDPR) enforce additional compliance burdens on businesses catering to the European audience.
Starting a subsidiary in a country like China helps companies manufacture cost-effective products.
- China is famous for its efficient manufacturing and production cost.
- It assists companies in minimizing overall production costs.
- China has implemented strict rules for work visas and permits for foreign employees.
Does the Global Minimum Tax Impact Foreign Subsidiaries?
Previously, the foreign subsidiary advantages and disadvantages depended entirely on the host country’s tax rates. It was a ‘race to the bottom’ with tax competition between governments to attract foreign investment.
It may now end with 136 countries signing a deal to ensure global companies pay global minimum tax. The countries behind the global minimum tax rate collectively account for over 90% of the global economy.
Economists expect that this global minimum tax rate deal will encourage multinationals to repatriate capital to their country of headquarters, boosting those economies.
Multinationals will continue to establish a separate foreign entity and measure the foreign subsidiary’s pros and cons based on business factors as discussed above.
Advantages of Establishing a Foreign Subsidiary
Forming a new entity or acquiring an established entity in a new market is beneficial for international expansion only after validating all the possible foreign subsidiary pros and cons.
Listed are some of the advantages a company gets while establishing a foreign subsidiary:
- The parent company is protected from business risks
- Establish market presence
- Protection under local laws
- High compliance with tax regulations
- Access to a global talent pool
- Flexibility of investment
- Physical asset acquisition
- Global Minimum Tax
The parent company remains protected from business risks
The significant advantage of foreign subsidiaries over a representative or branch office is that it is recognized as a separate legal entity from its parent company. Even though the parent company may hold majority shareholding rights, and the liabilities and risks associated with the failure of the subsidiary are generally kept isolated. This also means that both companies can share liabilities and will separate in terms of tax or regulations.
Establish market presence
Establishing a subsidiary in a foreign country establishes a legal entity in that country. These entities can then market their products to local people and participate in import and export.
A local client may prefer to engage and contract with a locally established company. Setting up your legal structure in any target country can gain valuable market perception, adding to your overall brand value and profits.
For instance, an American company establishing its subsidiary in the Netherlands will be called a Dutch company and is more likely to attract the local clientele.
Protection under local laws
Establishing a foreign subsidiary means having a legal entity recognized by the local government. Therefore, the enforceability of employment contracts or any legal matter is under the relief of local court systems.
High compliance with tax regulations
Forming a foreign subsidiary company in any target country will automatically kick in tax regulations and bilateral tax treaty requirements, ensuring the highest levels of compliance in that country. It would automatically cover the risk spectrum usually associated with cross-border trade.
Access to a global talent pool
One of the significant advantages of foreign subsidiaries is giving the parent company unlimited access to new markets. Besides, the parent company can hire full-time employees abroad directly based on their skill set.
New business relations
Establishing a legal entity also helps parent companies form business relations with local partners in foreign countries. They can, in turn, utilize localized knowledge and set up joint ventures. This will help boost the company’s revenue.
Flexibility of investment
Since the parent company controls a foreign subsidiary’s assets, it may invest as much or as little into the subsidiary. The level of investment depends on risks associated with the new market location or the business niche.
Not just that, if a foreign subsidiary company fails to achieve its desired outcomes, the parent or the holding company can choose to sell it and get its investment back.
Physical asset acquisition
Engaging the services of foreign independent contractors, BPOs, or even an Employer of Record (EOR) is usually preferred for quicker global expansion. However, establishing a foreign subsidiary protects your manufacturing or any other business requiring real estate acquisition or other physical assets.
Disadvantages of Establishing Foreign Subsidiaries
Subsidiaries also have certain disadvantages.
- Working problems in a foreign country
- Not suitable for a cost-plus approach
- Regulatory compliance
- Bureaucratic hurdles within the parent company
- Resource curse
Working problems in a foreign country
A foreign subsidiary is a local legal entity in its place of incorporation. However, any legal or financial action could have implications for the parent companies. Thus, the usual problems of working in a foreign country also apply.
As a foreign subsidiary is not developed organically in that country, it may have to face cultural and political issues. These could negatively affect the foreign subsidiary’s growth. Following local procedures and regulations to mitigate may increase compliance costs.
Not suitable for a cost-plus approach
The significant disadvantage of foreign subsidiaries comes into play when it sells products based on cost-plus pricing. Since the subsidiary is now contracting and invoicing locally, it increases local maintenance costs, adds tax complexities, and requires local signatories.
Usually, the cost-plus pricing strategy involves adding a fixed percentage on top of a unit cost and arriving at the selling price.
In the past few decades, the rise of global trade has forced national governments to open doors for foreign companies to set up their subsidiaries. Subsequently, several employment law violations, corporate malpractices, and international banking frauds have also made headlights.
In the context of the ever-changing regulatory landscape, a foreign subsidiary must stay updated on changes to national/regional/local tax laws, payroll withholdings, employment law changes, and banking regulations, to name a few.
Bureaucratic hurdles within the parent company
Taking decisions on a company level can become demanding for both the parent and the daughter company. It would mean that the decision-making process will take significantly longer and thus will involve more people.
Finally, both companies might have to hire a legal team to navigate the legislation differences in both countries.
As established already, one of the advantages of foreign subsidiaries is to tap into the local technical talent. However, practical difficulties in finding the right talent will always be a challenge. Hence, we refer to it as a resource curse.
There are optimized solutions available for staffing. Outsourcing the talent acquisition to trained professionals who are well versed with local laws and customs in the host country can choose the best candidates for any job opening in the subsidiary company.
After an elaborate discussion on the advantages and disadvantages of foreign subsidiaries, we recommend hiring an experienced team to aid your expansion efforts. Companies must be aware of all government rules and tax regulations to hire local employees and set up a subsidiary in another country. The procedure to set up a foreign subsidiary is time-consuming and expensive.
Partnering with the latest international EOR/PEO solutions from Multiplier can reduce costs for your company by taking over your global HR functions in over 150+ countries so that you can concentrate on your business.