Establishing a Foreign Subsidiary: Pros and Cons For Global Employers

Establishing a foreign subsidiary is the traditional route to expanding globally as a business. While it’s one way to grow as a company and establish your reputation as a global employer, the process can be lengthy, complicated and requires significant resources as a business.

This article will deep-dive into the pros and cons of establishing a foreign subsidiary and  the steps involved in setting one up. Plus, we outline alternatives that can save significant time and cost when expanding into new markets.

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What Is A Foreign Subsidiary?

A foreign subsidiary is a separate legal entity established by a parent company in another country. It operates independently but remains under the control of the parent company. Establishing such a subsidiary allows businesses to access new markets, mitigate risks, and optimize tax benefits. 

Companies often choose between wholly owned subsidiaries, where they hold 100% control, partially owned subsidiaries, shared with local partners, or joint ventures formed in collaboration with other entities.

Companies typically establish foreign subsidiaries to access new markets, mitigate their risks and optimize tax benefits. 

Types of Subsidiaries:

• Wholly Owned: The parent company holds 100% control.
• Partially Owned: Shared ownership with local partners.
• ‍Joint Ventures: Collaborative business operations with shared ownership.

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Foreign Branch vs Foreign Subsidiary

A foreign branch is not a separate legal entity and the parent company bears full liability for its operations. In contrast, a foreign subsidiary is a distinct legal entity, providing better legal protection and compliance independence. Understanding these differences is crucial for businesses to make informed decisions about their global expansion strategy.

Foreign Branch:

• Not a separate legal entity.
• Parent company bears full liability.
• Direct extension of the parent company.

Foreign Subsidiary:

• Separate legal entity.
• Independent liability and compliance.
• Provides better legal protection for the parent company.

Navigating Permanent Establishment Risk

Creating a foreign subsidiary can open up your business to permanent establishment (PE) risk, which subjects the parent company to local taxation and regulatory requirements. This risk underscores the importance of thorough research and compliance with local laws to avoid unexpected liabilities.

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Disadvantages of Foreign Subsidiaries

Establishing a foreign subsidiary involves high initial setup costs, ongoing operational expenses, and extensive research to ensure compliance with local regulations. The time-consuming nature of these tasks can strain resources and delay market entry. 

Cultural differences may also pose integration challenges, impacting organizational cohesion. Additionally, closing down a foreign subsidiary can be a complicated and costly process, requiring careful consideration and planning.

1. High Costs: Initial setup, ongoing operational, and administrative expenses.
2. Time-Consuming: Extensive research and compliance efforts.
3. Cultural Differences: Potential integration challenges within the organization.
4. Closure Complexity: Tedious and expensive process to dissolve the entity.

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Advantages of Foreign Subsidiaries

Despite the challenges, establishing a foreign subsidiary offer benefits too. They provide access to new markets, enabling businesses to expand their global presence and reach new customers. Subsidiaries can also offer tax benefits, taking advantage of favorable local tax regimes. 

By operating as a separate legal entity, a subsidiary reduces the parent company's legal risks. This structure allows for better division of labor and resource allocation, enhancing operational efficiency. Moreover, having a local subsidiary builds trust and credibility with customers in the new market, fostering brand loyalty.

1. Market Access: Enables local presence and market penetration.
2. Tax Benefits: Potential for favorable tax regimes.
3. Legal Risk Mitigation: Limits the parent company’s liability.
4. Operational Efficiency: Enhanced division of labor and resource allocation.
5. Brand Trust: Builds credibility and trust in the new market.

Often, it makes sense to open a foreign subsidiary if you're planning to hire many new employees in a new market, to justify the investment in time and cost.

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Steps To Set Up A Foreign Subsidiary

To establish a foreign subsidiary, businesses must conduct preliminary research into the target market to understand local employment practices and compliance requirements. Forming an expansion team and planning the hiring strategy for the new market is essential. Ensuring compliance with local labor laws will usually involve consulting with your own appointed team of legal, financial, and tax experts. 

Deciding on the appropriate entity structure, such as an LLC or corporation, is a critical step. Securing funding for both setup and operational costs is necessary, along with appointing a board of directors and management team. 

Gathering all necessary documentation, including business plans and legal agreements, and registering with local authorities are vital steps in the process. Finally, setting up operations involves hiring employees, establishing offices and infrastructure, and developing local partnerships.

1. Preliminary Research: Understand the target market, legal requirements, and business environment.
2. Expansion Team Formation: Plan your hiring and operational strategies.
3. Compliance Assurance: Adhere to local labor laws and regulations. Certain activities might require specialized licenses and permits.
4. Entity Structure Decision: Choose the appropriate legal structure (LLC, corporation, etc.).
5. Funding and Budgeting: Secure funding for setup and operational costs. Research what the minimum capital requirements will be to open an entity in the market you want to enter, as this differs from country to country.
6. Management Appointment: Designate a board of directors and management team. Complications can arise when there is a requirement for local resident directorship. The foreign director often needs to register and pay Social Security or other mandatory employee taxes in the country of the new incorporation, since they are treated as employees themselves. In many cases, directors have to be physically present for company registration.‍
7. Documentation: Prepare all necessary paperwork, including business plans and legal documents. Be prepared that in many cases, the documents will need to be notarized and apostilled.  ‍
8. Local Registration: Register with local authorities and open bank accounts. This involves tax, social security, workers compensation registration and other mandatory registrations, to provide employees with required statutory benefits and comply with local labor laws. This can delay the process. The bank account opening can also be delayed by the complexity of the group structure, the number of Ultimate Beneficial Owners (UBO), and setting up required trusts. This can take up to 9 months, depending on the location.‍
9. Operational Setup: Hire employees, establish offices, and set up infrastructure. Take into account that this will include significant overhead costs such as rent.‍
10. Continuous Monitoring: Regularly review compliance and performance metrics of your newly established foreign subsidiary.

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What Are The Alternatives To Setting Up a Foreign Subsidiary?

For businesses seeking a less complex and cost-effective approach to hiring internationally, there are two alternative solutions:

Hire independent contractors

Employing contractors allows businesses to manage overseas operations without establishing a legal entity, though it’s only suitable if you’re looking for support with short-term projects.  Treating contractors the same as a full-time employee carries misclassification risks.

Partner with an Employer of Record (EOR) 

An Employer Of Record is a third party service that assumes all employer responsibilities on your behalf in new regions, handling payroll, taxes, and compliance with local employment laws. 

It offers a route to quick market entry and vastly reduces the financial and administrative burden for businesses, offering an alternative to the traditional method of establishing legal entities.

Companies often use Employer Of Record services for the following reasons:

• They can make their first few hires in a region without committing substantial resources to first establish a foreign subsidiary or legal entity in order to do so. This means businesses can test the viability of new markets at a much faster pace, at low costs.
• It's easier to withdraw from the market if things don't go according to plan, as opposed to shutting down a foreign subsidiary.
• As a business, you can establish your organization as a leading, global employer and offer remote work opportunities to the best talent, no matter where they are based.

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Start Your Global Expansion with Playroll

 Playroll's EOR services can be a strategic solution for businesses looking to expand globally without worrying about the complexities of setting up a foreign subsidiary.

Playroll has a global footprint in 180+ regions, and teams of experts on hand to help navigate international hiring and ensure you stay fully compliant – with direct support for employers and employees, every step of the way. Hire, pay and manage a global workforce, all in one platform.

Speak to our experts to find out how Playroll can help you scale your global workforce.

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