In many cases, international expansion involves establishing a new location. Businesses have a lot of options for legally integrating this new location into their organization—including establishing a foreign subsidiary.

In this article, we explain what a subsidiary is and how it differs from a permanent establishment. We also compare the advantages and disadvantages of a subsidiary abroad and explain when it makes the most sense to set one up.

What’s in this article?

• What is a subsidiary?
  
• What is the difference between a subsidiary and a permanent establishment?
  
• What are the advantages of having a subsidiary abroad?
  
• What are the disadvantages of having a subsidiary abroad?
  
• When should you establish a foreign subsidiary?
  

What is a subsidiary?

A subsidiary is a business subject to the influence of another business, typically called the “parent business.” The parent business owns shares in the subsidiary, giving it significant influence over the subsidiary’s strategic decisions.

A parent business can own as little as 10% of its subsidiary; though in practice, the parent business typically holds a majority of the shares. If the parent business owns all of the shares, the subsidiary is what’s called a “wholly owned subsidiary.” Regardless of the shareholding structure, a subsidiary is legally independent. This means it can, for example, enter into its own contracts and sue or be sued by third parties.

The legal basis for this is Section 271 and Section 290 of the German Commercial Code (HGB). There is no specific legal formation required for a subsidiary. There are corporate structures that include partnerships or natural persons as subsidiaries. However, most are a limited partnership (KG), limited liability company (GmbH), or public limited company (AG).

Regardless of its legal formation, the business is an independent legal entity. However, it is not economically independent. The specific nature of the legal relationship between the controlling parent business and the subsidiary is defined in a control agreement. In most cases, businesses also conclude a profit transfer agreement. Through this, the subsidiary agrees to transfer its profits to the parent business.

What is the difference between a subsidiary and a permanent establishment?

Establishing a foreign subsidiary is not the only way to expand into new markets with a physical, on-site presence. German businesses can also open a permanent establishment abroad.

According to Section 12 of the German Fiscal Code (AO), a permanent establishment is any fixed place of business or installation that serves the activity of an enterprise. Operating locations can be, for example, business offices, warehouses, or production facilities. Assembly and construction work can also function as a permanent establishment if they last for at least six months.

Here are the main differences between a permanent establishment and a foreign subsidiary:

Legal independence

A subsidiary has legal independence. On the other hand, a permanent establishment is not an independent legal entity. It is merely an organizational unit of the parent business. Since it is a dependent branch and not a separate legal entity, it can only act in the name of the parent business.

Liability

Since a permanent establishment is not a separate legal entity, the parent business is responsible for all liabilities, including financial obligations and legal claims. However, in the case of parent businesses and subsidiaries, the separation principle generally applies. A parent business is not liable for its subsidiaries, and subsidiaries are not liable for their parent companies.

Liability is limited to the corporate assets of the business concerned. In individual cases, however, the liability of subsidiaries depends on many factors, such as the contractual arrangements, legal forms of the business, cash flows, and conduct of the businesses toward each other.

Taxation

The profits of a permanent establishment are usually taxed in the country where the permanent establishment is located. Thanks to double taxation agreements—which aim to prevent taxpayers from being taxed multiple times on the same income—the parent business’s home country usually either exempts the permanent establishment from taxation or offsets the tax amounts.

The actual tax burden depends on several factors, including the tax rate applicable in the target country and the legal formation of the parent business. In the case of a sole proprietorship, profits are taxed in the country of the permanent establishment at the income tax rate applicable there. If the parent business is a corporation, the profits of the permanent establishment are subject to foreign corporate income tax.

Similar tax principles as those for permanent establishments apply to foreign subsidiaries if they are established as partnerships. If the partnership is also recognized as such abroad, its income is taxed only once in the country of the partnership—regardless of whether the profits are withdrawn by the partners or not.

To ensure a clear separation of taxation between the business and its shareholders, it makes sense to establish a foreign subsidiary as a corporation. Its taxation is based on the corporate tax rate of the country where it is located.

Profit shares

Profit shares paid by a foreign subsidiary are generally subject to local withholding tax; although, this is limited by double taxation treaties. Within the EU, the withholding tax can be reduced to 0% under certain regulations. In Germany, dividend distributions are taxed differently depending on the type of shareholder.

Sole proprietorships and partnerships with natural persons as partners must pay tax on 60% of their dividends, which is known as the partial income method. For corporations holding at least 10% of the subsidiary, the dividends are taxed according to a more favorable regime in accordance with Section 8b of the German Corporate Tax Act (KStG). Only 5% of the dividend is subject to tax.

What are the advantages of having a subsidiary abroad?

Establishing a foreign subsidiary offers businesses various advantages:

Market access

Establishing a subsidiary is a good option for entering a new foreign market. Direct presence on site can facilitate new business partnerships and support the maintenance of customer relationships and networks. Additionally, businesses can increase their awareness and improve their competitive position in the target market and internationally.

Flexibility

As a legally independent entity, a foreign subsidiary provides a greater degree of control over operational decisions. Operational independence leads to greater management flexibility. This also enables subsidiaries to react more quickly to local market changes without affecting the activities of the parent business.

Local expertise

A key advantage of having subsidiaries abroad is the ability to tap into local expertise by employing local staff. Locals possess indispensable knowledge about cultural nuances, market trends, and regulatory frameworks. Local employees will also help you overcome language barriers and build trusting relationships with authorities and business partners.

A physical presence in a target market can also increase customer intimacy. Having a better understanding of their needs and expectations makes it easier to develop customized products, services, or marketing strategies.

Limited liability

The legal independence of a subsidiary means the parent business is liable only up to the amount of capital contributed to the subsidiary.

It does not have to guarantee the subsidiary’s liabilities with all of its assets. This protects the parent business from extensive financial damage that could result from economic difficulties or legal disputes at the subsidiary.

Tax advantages

By establishing a subsidiary abroad, businesses can benefit from tax advantages.

Many states offer reduced tax rates for businesses to make the location more attractive. This can take the form of lower corporate tax rates, tax breaks for certain industries, or investment incentives, such as tax credits or special depreciation allowances. In addition, double taxation treaties prevent income from being taxed twice.

What are the disadvantages of having a subsidiary abroad?

Although there are many advantages, establishing a foreign subsidiary comes with a few downsides as well:

High costs

The establishment and operation of a foreign subsidiary is associated with high administrative and financial costs. To comply with the legal and tax requirements of the target country, high initial investments are required in the startup phase (e.g., for consulting services). Developing market entry strategies—including market analysis, advertising campaigns, and product range adjustment to local needs—can also be costly. Finally, there are costs for personnel, rent, and supplies.

Conflicts of interest

One possible disadvantage of running a subsidiary is the risk of conflicts of interest with the parent business. These can arise when business objectives or priorities do not coincide. Parent businesses usually focus on overarching corporate goals such as global market success. Subsidiaries might be more focused on local market conditions, short-term growth goals, or specific customer needs.

Political and economic instability

If German businesses plan to establish a subsidiary abroad, they should also investigate the potential target market’s political and economic stability. Changes in government, political unrest, inflation, or currency devaluations can severely affect the economic climate and increase the financial risk for businesses.

The advantages and disadvantages of a foreign subsidiary at a glance

When should you establish a foreign subsidiary?

A subsidiary is often established when the parent company wants to expand its business activities. If the new branch no longer fits into the original core business, it can be outsourced as a subsidiary.

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Large corporations can use subsidiaries to differentiate between different areas of business. This creates more transparency and clear accountability. Subsidiaries are common, especially when expanding into foreign markets.

A subsidiary can also be established with the intention of selling all or part of it at a later date. It is generally easier to sell a business unit if it is managed as a separate legal entity.