BRANCH OFFICE VS SUBSIDIARY?
By Himanshu Joshi, for Legal Corner LLP. Himanshu is a final year student of NALSAR University of Law, Hyderabad.
(The views expressed here are not to be considered as legal opinion. You may not rely on this article as legal advice. You should reach out to me (chetana@legalcornerllp.com) if you need assistance with incorporation of your entity in the US so as to get legal advice that is specific to your business needs).
It’s time to expand your business overseas. Before you open your doors, you must make a critical choice — one whose impact is often underappreciated: whether to open a branch office or a subsidiary?
While it may seem like a matter of semantics, a branch office, in legal terms, is wholly different from a subsidiary. And deciding on one entity over the other comes with substantial liability and compliance consequences. Opening an international office means asking complex questions about your company’s tolerance for legal risk, how the enterprise might be taxed and what compliance challenges it might face.
Herewith is an explanation of the basic entities available to companies when they organize new offices overseas, a few of the benefits (and potential pitfalls) of each and other factors to consider before making a final decision.
A direct extension — Representative and Branch Offices
First, let’s define our terms. Generally, companies have three options when they want to enter a foreign market: a representative office, a branch office or a subsidiary.
The representative office is, in essence, a beachhead. It is the simplest to establish as it only exists to allow the company’s representatives to make contacts in the local market. Promotional activities are acceptable, but companies must take care not to step over the line. In most countries, a representative office cannot handle transactions or contractual matters.
A branch office, on the other hand, is a direct extension of the parent company and can engage in core activities like sales and contracts. It is designed to help generate revenue for the company and serves a particular geographic region.
Pros and cons between branch offices and subsidiaries
Branch offices and subsidiaries both offer benefits and challenges for a growing company. Let’s tackle first a few of the pros and cons involved in choosing a branch office:
- Branch office pros and cons
Speed (pro): A branch office can be set up relatively quickly — though, as we’ve noted, it is not without its bureaucratic hurdles. Some companies use a branch office as an interim step, using it to gain local knowledge and make sales before acquiring or establishing a subsidiary.
Oversight (pro): A branch is a part of the parent company and is dependent upon it. Management decisions flow directly from company headquarters, offering executives a greater measure of direct control.
Cost (pro): Branch offices tend to be smaller in size, reducing overhead costs.
Liability (con): Because they are not separate entities, branch offices provide no liability protection for a parent company. The parent is on the hook for any legal issues that may arise.
Tax worries (con): Depending on the applicable tax laws, companywide profits may be exposed to taxation in the country where the branch is located.
- Subsidiary pros and cons
Protection (pro): Because a subsidiary has its own legal status, it provides a parent company with an additional layer of protection from liability.
Tax Limitations (pro): Subsidiary companies are taxed under local laws on their own income, thus shielding the parent company’s profits from taxes in a foreign country.
Credibility (pro): A subsidiary may open access to capital from banks and investors more comfortable with investing in a local company.
Compliance (con): Because a subsidiary is a separate entity, it may require multiple government registrations and may need to maintain a minimum level of capital to operate. It is also likely to face more stringent local regulations and annual reporting requirements.
Political Exposure (con): As the tariff disputes pitting the United States against China and others have shown, a company’s subsidiaries may be exposed to political risks beyond their control. As tariffs rose, some domestic manufacturers felt the effects because they owned a subsidiary in a country that had been penalized.
Making a choice in India and USA
As for India, a foreign company should generally prefer opening up a subsidiary company over a branch office. With respect to a subsidiary company, the compliance requirement for incorporation is simplified and easy to fulfill while a branch office cannot carry out manufacturing or processing activities in India which a subsidiary company can do. Furthermore, the Corporate Income Tax (CIT) applicable to a subsidiary company is comparatively less than a Branch office and the assets of the parent company can be attached in case the liabilities of the branch office in India exceeds the value of assets of the parent/foreign company.
In the U.S.A, there is no specific legal registration required to establish a ‘branch’. However, a branch of a foreign company may subject that foreign company to direct legal claims and liability for the acts and business of the branch. For this reason, many foreign investors prefer to do business in the U.S. by forming a corporation to help insulate the foreign company from liability. In addition to the U.S. income tax on the branch earnings, a foreign corporation may also be subject to a branch profits tax with regard to its U.S. branch earnings. The amount of tax imposed (up to a 30% rate) is calculated based on ‘dividend equivalent amounts’ to the foreign corporation, i.e., the amount of any reduction to branch equity in a given year, limited to the branch’s cumulative net earnings. The branch profits tax is a second layer tax that is imposed directly on the foreign corporation and is payable in addition to the foreign corporation’s regular U.S. income tax liability.
Without proper due diligence, if a company chooses an entity, it may stifle rather than encourage its overseas growth. Entering a new market may be exciting for a growing company, but it also means grappling with a whole host of unfamiliar rules and regulations. Choosing a trusted and experienced global corporate compliance partner can allow your company to smoothly navigate a host of compliance issues, provide insights on planning for an international location and help you create and register a legal entity when you’ve chosen the right one for your company.
If you have any questions regarding the incorporation process, please email me at chetana@legalcornerllp.com . I will be happy to set up a free consultation.