How to create a subsidiary in a foreign market

Sooner or later, every successful business will get to the point where it’s time to think about expanding into new markets. Global expansion comes with numerous challenges, one of them being the creation of foreign subsidiaries.

Creating a foreign subsidiary is often the best option for businesses that want to become fully operational in a new target market and start building a real local presence. But before going down that route, businesses need to know exactly what they’re in for.

What is a subsidiary company? What are the pros and cons? How to create a subsidiary in another country? Why go through the trouble of setting up a foreign subsidiary? What are the alternatives?

A subsidiary (or subsidiary company) is a legal entity that is owned and controlled by another company, the latter being called the parent company. The parent company (or holding company) must hold more than half the subsidiary’s stocks—otherwise, the legal entity is not considered a subsidiary.

Subsidiaries whose shares are entirely in the hand of the parent company are called wholly-owned subsidiaries. But even in cases where the parent company doesn’t hold all of the subsidiary’s equity, the holding company will exercise a high level of control over the subsidiary—for instance, by electing the subsidiary’s board of directors.

One key characteristic of subsidiaries is that they are completely separated from the holding company from a legal point of view. This means that they are distinct legal entities that operate independently under their own management team. While the subsidiary’s financial data is reported to the parent company, corporate taxes and other liabilities are managed separately.

What is a foreign subsidiary?

A foreign subsidiary is a legal entity which is registered in a country other than the country where the parent company is located. Foreign subsidiaries are subject to local laws and regulations regarding taxation, compliance, incorporation, and more. In contrast to a representative office or branch, a foreign subsidiary company protects the parent company from any liabilities that may arise in the foreign market.

Whenever there is a decision to make in the corporate world, company owners and business leaders have to carefully weigh the pros and cons. It’s no different when deciding on whether or not to create a subsidiary company.

The pros of creating a subsidiary company

The main advantages of setting up a subsidiary are:

• Liability shield for the parent company,

• Protection from financial losses,

• Lucrative synergies with other subsidiaries, 

• Greater efficiency, and

• Possible tax benefits.

The cons of creating a subsidiary company

On the other hand, there also are a few drawbacks to consider when setting up a subsidiary. They include:

• More complicated accounting for the parent company due to financial consolidation,

• Limited control to ensure the legally necessary level of independence for the subsidiary,

• No complete protection from legal liabilities,

• Potential conflict of interest,

• Additional legal costs, and

• Need to deal with additional bureaucracy.

The main reason why companies create or buy subsidiaries is to realize profitable business synergies, simplify the management of multiple brands, businesses, and products, gain new market shares, or acquire certain assets.

The purpose of creating a foreign subsidiary company is to venture into a new market while mitigating associated financial, operational, and legal risks. Since a subsidiary operates as an independent entity, the parent company can protect itself from liabilities that may arise in the foreign market.

The necessity to create a foreign subsidiary typically arises when the parent company faces permanent establishment risks. Permanent establishment (PE) is when a company is found to have a taxable presence in a country other than the one in which it is registered.

Without a registered subsidiary, the tax liabilities resulting from the business activities carried out in the foreign market fall back onto the parent company. In the worst case, this could mean that the holding company has to pay corporate taxes on its global revenue.

PE risks can be triggered by numerous different factors, including:

• Fixed business location in a foreign market,

• Engaging in revenue-generating business activities, and

• Hiring employees in a foreign market whose work is directly linked to revenue creation.

In order to avoid PE risks resulting from any of the triggers listed above, businesses typically resolve to create a foreign subsidiary, which is the only type of foreign legal entity that can act as a liability shield for the parent company. Representative offices or branches cannot protect the parent company from liabilities arising in the foreign market.

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There are different steps businesses have to follow when setting up a foreign subsidiary. The formal requirements and exact procedures may differ depending on the country, but the basic process outline is as follows:

• Carrying out the necessary preliminary research: Before creating a foreign subsidiary, businesses need to do their due diligence and research all the necessary aspects, such as limitations on foreign direct investment (FDI), visa requirements for shareholders and business directors, legal restrictions and regulations that apply in the respective industry or sector, and more.

• Forming an expansion team: Expanding into a new market requires an experienced team who is familiar with risk mitigation strategies, incorporation procedures, international compliance, and more. The expansion team should be present to oversee the entire process from start to finish.

• Choosing a legal entity type: Legal entity types differ from one country to the next. Before deciding on a certain type of business entity, the expanding business needs to compare different options and choose the legal entity type that best matches the planned business venture.

• Appointing a management team: The next step is to choose the members of the executive management team and the members of the board of directors. It is important to check the country-specific regulations regarding the appointment of directors. Some countries require a certain number of local directors to be part of the board.

• Gathering all the necessary documentation: Creating a subsidiary company requires several legal documents, including a detailed business plan, the articles of organization, indemnification agreements, and more. Also, this is where the funding for the applicable capital requirements should be wrapped up.

• Registering with the local authorities: Next is the official incorporation of the subsidiary. This includes registering the company with the respective authorities to make everything official. Once the subsidiary company is registered, it is possible to apply for the necessary identification numbers for acting as an employer, withholding payroll taxes, etc. Another task is to set up a local bank account.

• Setting up operations and forming local partnerships: Once all the administrative tasks are completed, the next step consists in setting up the necessary infrastructure and facilities to make the subsidiary operational. This includes anything from accounting and payroll to IT and supply chain. Also, it’s never too early to start developing local partnerships.

Businesses should also keep in mind that the cost and time required to set up a foreign legal entity vary significantly from one country to the next. Both the financial and time requirements of creating a foreign subsidiary are important criteria when deciding where to expand—along with many other factors that make a good destination for international business expansion.

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There are different alternatives to establishing a foreign subsidiary company, depending on what the parent company is looking to achieve in the new target market. Here are a few options to choose from.

Working with contractors

Working with independent contractors and freelancers doesn’t require the creation of a local legal entity. That’s because freelancers and contractors pay their own taxes and social security contributions and are not officially employed by the business that is using their services.

Engaging contractors or freelancers is typically the first step when entering a new market, since it represents the lowest level of commitment. This means that withdrawing from the market is easily possible at any given moment without financial losses or complex legal processes.

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Using an Employer of Record to hire employees abroad

Businesses that only want to hire a couple of local employees to test a new market and start building a local presence for their brand should consider using an Employer of Record before going all in by creating a foreign subsidiary.

An Employer of Record (EOR) is an employment outsourcing service provider that allows businesses to compliantly hire employees in another country. Since the EOR takes on the role of the employee’s legal employer, the client business doesn’t need to set up a local business entity.

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Creating a branch or representative office

Creating a foreign subsidiary offers the parent company a range of benefits. A subsidiary is fully operational in the new market and can engage in any revenue-generating business activities without restrictions. Plus, since it’s a distinct legal entity, it protects the holding company from any tax liabilities or similar.

However, depending on the business plans for the new target market, it might not be necessary to go through the complex incorporation process. Branch offices or representative offices are good options for expanding businesses that want to keep their presence in the new market limited.

Global expansion is an important step in a business’s growth trajectory. At some point, every expanding business will be faced with the challenge of setting up a foreign subsidiary to get full access to a new market.

While creating a foreign subsidiary reduces risks, helps gain the trust of local customers, and generally makes it easier for the business to operate in the new market, incorporating in a different country can be challenging.

From ensuring compliance with in-country employment laws when hiring local employees to setting up local payroll, there are many challenges to navigate. In order to avoid legal pitfalls that could put the success of the expansion project at risk, businesses should consider using a global employment and payroll solution like Lano.

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Lano gives businesses access to a global network of trusted EOR and payroll partners who offer their services across more than 170 countries worldwide. Easily and compliantly hire local talent to test new markets before deciding whether or not to set up a local entity.

Already got a foreign subsidiary but still missing the knowledge on how to process and manage local payroll? Then use one of our in-country payroll partners to get your local payroll up and running in record time. Book a demo with one of our experts to learn more.