What Is a Foreign Subsidiary?

Expanding your business into new markets can be a lucrative opportunity for growth, but there are so many ways to approach it. Setting up foreign subsidiaries is a popular method, but it’s not the best option for all companies or global expansion strategies.

This article will help you weigh up the pros and cons of establishing a foreign subsidiary and identify when (and if) it’s the right option for your company. We also present an alternative for the early stages of international expansion, which can help you minimise risk. Now, let’s tackle the question at hand, what are foreign subsidiaries, exactly?

What Is a Foreign Subsidiary?

A foreign subsidiary is an overseas company owned or controlled by a larger enterprise based in another country. Foreign subsidiaries are separate legal entities that must comply with the laws and regulations of the local jurisdiction. They’re also responsible for their own assets and taxes.

To break it down further, a foreign subsidiary must abide by the following:

Local labour laws
Local tax codes
Local reporting requirements
Local corporate governance standards

It is also responsible for its own legal and financial obligations, such as:

Filing taxes
Maintaining its own accounting records
Managing contracts and employment agreements

Operationally, a foreign subsidiary has its own management team and can make decisions independently, typically in alignment with the parent company's strategic objectives. This structure allows the subsidiary to tailor its operations to local market conditions while still benefiting from the parent company's resources and support.

Google is one of the most popular examples of a large international company with numerous foreign subsidiaries. While its headquarters is in California, USA, it has over 40 subsidiaries across the world.¹

How Does a Foreign Subsidiary Work?

To be classed as a foreign subsidiary company, the business entity must be more than 50% owned by a foreign parent company or holding company. If the parent company owns 100% of the shares, this is called a wholly owned subsidiary.²

The parent company, along with any other shareholders, should elect a board of directors to maintain control over the management and operations of the foreign subsidiary. This structure is quite different from how domestic corporations operate within their home country.

Foreign earnings of a subsidiary can significantly impact the financial statements of the parent company, influencing both tax obligations and overall profitability. If a parent company owns less than 50% of the foreign entity’s shares, it’s designated an associate or affiliate company instead.

Foreign Branch Vs. Foreign Subsidiary

Both foreign branches and foreign subsidiaries can enable businesses to expand internationally, but there is a key difference between them. A local subsidiary is legally and fiscally separate from its parent or holding company, whereas a branch office is not.

This means a parent company remains liable for a branch office but not for a subsidiary. Our separate guide about setting up local entities explains more about branch offices.

Foreign Subsidiary Vs. Permanent Establishment

Permanent Establishment (PE) is a concept or state of being rather than an entity type. Tax authorities generally define a Permanent Establishment as a permanent, ongoing, and revenue-generating setup within its jurisdiction. As such, it may be liable to pay corporate taxes in that jurisdiction.

Because of this definition, a foreign subsidiary is by its very nature a PE. However, many other types of entities or business structures may be considered a Permanent Establishment, too, including branch offices and affiliate companies. A business may even create PE by hiring staff abroad without opening a physical office.

If you’d like to understand exactly what triggers PE, take a look at our guide on Permanent Establishment. Learn about its risks and how they can potentially impact your business.

Foreign Subsidiaries & PE Risk

While a foreign subsidiary pays corporate tax separately, the parent company could still be exposed to PE risk if it’s found to be doing business for itself through the foreign subsidiary. In this situation, the parent company may become liable for paying corporate taxes, in addition to potential fines.

Factors to Consider Before Establishing a Foreign Subsidiary

As you contemplate setting up a foreign subsidiary, there are multiple factors to take into account:

Market potential – Consider the size, growth potential, and competitive landscape of your target market. A substantial and growing market can help justify the investment in a subsidiary.
Regulatory environment – Evaluate the host country’s legal and regulatory framework, including foreign investment restrictions, compliance requirements, and ease of doing business.
Cost-benefit analysis – Conduct a thorough analysis, comparing setup and operational costs against expected revenue and strategic advantages.
Resource availability – Determine whether you have the financial, human, and operational resources to support a subsidiary.
Risk assessment – Identify any potential risks, including political instability, economic fluctuations, and cultural differences, and develop mitigation strategies if you plan to move forward.
Long-term objectives – Make sure your final decision aligns with your company’s long-term strategic objectives.

Carefully weigh these factors, as the complexities and risks involved in setting up a wholly owned foreign subsidiary can outweigh the potential benefits. Such a move must support your broader strategic goals and the resources available.

Ideal Conditions for Establishing a Foreign Subsidiary

There are instances when opening a foreign subsidiary can be the right decision.

Local presence – Developing a strong local presence can help your organisation effectively compete, understand customer preferences, and build brand loyalty.
Operational standards – If your business seeks to maintain high production, quality, and supply chain management standards, a subsidiary’s direct oversight can help guarantee consistency and reliability.
Regulatory advantages – Operating as a local entity can also provide certain regulatory advantages, such as eligibility for government incentives, tax benefits, or favourable trade agreements, giving your company an edge over its competitors.
Customer proximity – Being close to key customers can improve relationships and service delivery, increasing customer satisfaction and retention rates.
Competitive necessity – A subsidiary is sometimes necessary to achieve success in highly competitive markets, especially when major players are local or have local subsidiaries themselves.
Strategic alliances – Operating a foreign subsidiary can facilitate strategic partnerships with regional businesses, providing avenues for collaboration, market entry, and growth.

On the flip side, there are also times when establishing a foreign subsidiary might not be in your company’s best interest. For example, the investment might not yield sufficient returns if your target market is too small, stagnant, or highly competitive with limited growth potential.

High regulatory barriers, complex compliance requirements, and an unfriendly business environment can also pose challenges and costs that outweigh the benefits. Additionally, if your company lacks the necessary resources to support a subsidiary or the risks associated with political instability, economic fluctuations, and cultural differences are too high, it may be wiser to explore alternative expansion strategies.

Do You Need a Foreign Subsidiary for Global Expansion?

The short answer is no; you don’t necessarily need to set up a foreign subsidiary to expand your business internationally. It’s just one of many ways to enter a new foreign market, and while it’s certainly the best option for some businesses, it may not be for yours.

Establishing a foreign subsidiary is a time-consuming and expensive method of entering a new market, so you need to carefully weigh the pros and cons before committing.

If you’re in the early stages of global expansion and haven’t yet validated a new market, opening a foreign subsidiary probably isn’t the best option for your business. Before setting up shop permanently in a new market, you should test the waters to determine if it has true value and longevity.

During this period, keeping your legal and financial footprint as light as possible is wise. This will allow you to withdraw from the market easily if necessary. Hiring a small, local team to conduct market research is an effective way of gathering more intel before establishing permanent roots. And to hire international talent, you don’t even need to set up a local entity - you can use an Employer of Record (EOR) like Omnipresent instead.

Once you’ve validated a market and are committed to growing your business there, establishing a local entity could be the next logical step in your expansion process. This local entity might take the form of a foreign subsidiary or a host of other entity types, like a joint venture, branch office, affiliate company, or partnership.

To determine which option is best in your circumstances, first assess your company’s:

Global expansion strategy
Company objectives
Financial health
Available resources
Logistical capabilities

You should also consider each market’s regulatory limitations regarding foreign investment. Understanding these regulations is key to ensuring compliance, avoiding legal complications, and mitigating risks associated with operating in a foreign jurisdiction.

Pros of Establishing a Foreign Subsidiary

Establishing a new foreign subsidiary can benefit your business when executed at the right stage of international expansion. Below, we outline several of the key advantages of setting up this type of entity.

It Offers Financial Benefits

Operating a foreign subsidiary can lead to significant cost savings. For instance, many countries offer lower labour and production costs.³ Your company may also be able to take advantage of local tax incentives, subsidies, grants, resources, and other financial benefits host countries offer to attract foreign investment. Moreover, a subsidiary pays corporate taxes separately from its parent company, providing financial flexibility and potential tax savings.

It Protects Your Parent Company

Unlike a representative or branch office, a foreign subsidiary is treated as a separate legal entity from its parent company. While the parent company still controls how its subsidiary operates, liability and risk are generally isolated.

It Facilitates Market Expansion

Establishing a foreign subsidiary allows businesses to tap into new and emerging markets, increasing their global footprint and reaching a larger customer base. This diversification can reduce your company’s dependency on domestic markets and help your team better understand and respond to local consumer preferences and market trends. Note, however, that this can also be achieved through other methods with potentially lower risk and investment.

It Creates Trust & Credibility

In many countries, having an official business presence like a foreign subsidiary can help generate more credibility for your company. Local businesses, governments, industries, and consumers will likely take your company more seriously because it complies with all local regulations. This can increase overall brand trust and recognition in your new market, potentially translating into a powerful competitive advantage.

It Provides Access to Local Resources

Certain regions boast abundant natural resources or specialised expertise that may not be as readily available elsewhere. A foreign subsidiary can offer direct access to these resources, which may include raw materials, skilled labour, or advanced technology. Such access can substantially increase your company’s production capabilities and foster innovation.

Cons of Establishing a Foreign Subsidiary

While your global expansion strategy may benefit from establishing foreign subsidiaries, you also should know that it’s not a simple process. There are some big challenges you’ll have to overcome to make it a success, such as the following.

It’s Expensive & Resource-intensive

Foreign subsidiaries require a large investment from the offset, both in terms of money and resources. In addition to expensive setup and running costs, your team—including senior management—will need to dedicate a lot of time to establishing and maintaining a foreign subsidiary, which may detract from other high ROI activities. This risk increases in volatile or emerging markets.

Some common financial risks related to subsidiaries include:

Currency fluctuations
Economic instability
Unexpected operational costs

It’s Riddled with Regulatory Challenges

Operating a foreign subsidiary requires navigating complex and often unfamiliar regulatory frameworks. Compliance with local laws, regulations, and reporting requirements can be time-consuming and costly. Worse, if your company doesn’t properly adhere to these sometimes confusing regulations, it will have to contend with legal penalties or operational disruptions.

Partner with Omnipresent to avoid these headaches. An experienced EOR, Omnipresent helps companies worldwide achieve global compliance with international regulations and global employment laws.

It Requires Local Expertise

Navigating a foreign country's cultural, political, legal, tax, and bureaucratic systems is complex. Without seeking (often expensive) local expertise, your global expansion plans have a much higher chance of failure. Plus, managing a foreign subsidiary will add layers of complexity to your overall corporate governance and management. There will be varying time zones, languages, and legal systems to coordinate.

It’s Tricky to Dissolve

If your market doesn’t deliver as expected, closing down a foreign subsidiary can be hard work. In some jurisdictions, it can take as long, if not longer, to dissolve a subsidiary than to set one up in the first place. You need to consider closing bank accounts, ending office leases, liquidating investments, giving employees enough notice, and much more.

Weighing up the Pros & Cons

Due to the time, effort, and resources needed to establish (and dissolve) a foreign subsidiary, you need to be confident it’s the right strategic move before proceeding. Foreign subsidiaries can be beneficial for international expansion, but only once you’ve validated your new markets.

Consider conducting a thorough SWOT analysis to assist you in making your decision.⁴ Evaluate key factors such as your company’s internal capabilities, market conditions and potential, cost implications, operational requirements, and the regulatory environment. This structured approach will give you an idea of the potential impact establishing a foreign subsidiary may have on your business.

Remember, at the beginning of your expansion efforts, it’s best to be as agile as possible by hiring a small but experienced team on the ground. They can help you assess the landscape, conduct further market research, and test the market so you know that it’s worth investing in the long term.