Subsidiary Versus Branch Office

Subsidiary Versus Branch Office:  The PROS (+) and CONS (-)

International companies in Hungary operate mostly through subsidiaries, while the establishment of  a branch office or a  representative office provides further interesting alternatives. There are major differences between the three forms of operation, therefore, it is important to be aware of the relevant compliance, tax and liability aspects in order to avoid expensive surprises. Below, we compare the pros and cons.

Subsidiary or branch office?

While in this article our primary focus lies on the distinctive features of branch offices,  we would like to briefly define subsidiaries as distinct legal entities with limited corporate liability. Subsidiaries of foreign companies in Hungary typically operate in the form of limited  liability companies (Kft.: LLC or Ltd.) or companies limited by shares (Rt.: LC). The parent company and the subsidiary are not liable for each other's debts or obligations.  

Branch office

A branch office of a foreign enterprise can be established by registration into the company register. The company can own several branches and these can also maintain several places of business.

In many cases, international companies choose to set up a branch office for specific business reasons, often because the branch does not qualify as a separate legal entity. Thus, the branch has direct access to the assets, contracts and licenses of headquarters and can operate within the same legal framework. Specific sectors, such as banks, insurance companies and some commercial enterprises frequently operate in the form of branch offices abroad.

Establishing a branch can also provide tax benefits. In many cases, businesses can benefit from a more favorable tax treatment for assets and investments, the possibility to utilize a negative tax base that might otherwise be lost, apply more favorable transfer pricing rules and have access to an extended double tax treaty network.

Legal aspects of a branch office

A branch office is an integral part of a foreign enterprise, although it is registered in the company registry as a separate business entity. The assets necessary for its operation are provided by the foreign enterprise and are to be shown as subscribed capital in the balance sheet. The foreign-based enterprise and the branch are jointly and severally liable for the debts incurred in the course of the branch's activities. The employees of the branch are employed by the foreign company, while the employer's rights are exercised by the branch.

Taxation of the branch

The foreign company is considered a Hungarian taxable person in respect of the economic activity carried out by the branch in Hungary, so it is subject to tax both in its own country and in Hungary. Double taxation is eliminated via double tax treaties.

Combining two tax systems in this way can lead to a number of tax advantages, but it is important to make sure that the branch's tax liability in Hungary is not extended to headquarters itself. The latter may be the case if  the parent company carries on business in Hungary outside of the of the branch office, for example, by directly providing services to Hungarian clients.

So far as the business transactions between the  branch and headquarters are  concerned, these are to be treated for corporate income tax purposes as though they occurred between two independent entities, that is, the arm’s length principle applies. In the area of transfer pricing, branches should pay special attention to treating headquarters as a separate enterprise from a tax point of view, especially  when allocating and documenting operating costs. Further delicate topics are the payment of interest and license fees as well as management and marketing functions provided by headquarters, because these are often questioned by the tax authorities.

Accounting, financial audit, publication of reports of the branch office

The branch office qualifies as a Hungarian resident from the point of view of currency operations, however, it may choose to  maintain its books  in Hungarian Forint (HUF) or in the foreign currency of its choice. It is also entitled to choose a business year which diverges from the calendar year. The accounting of the branch is subject to Hungarian accounting rules (GAAP), however, the branch may also opt for the application of IRFS. These rules allow the branch's accounting to be optimally aligned with the parent company's accounting system.

As a general rule, annual financial audits and the publication of financial statements are mandatory for branches also. However, the Hungarian branch of a foreign company with its registered office in a Member State of the European Union as well as in Iceland, Liechtenstein and Norway is exempted from the obligation to publish its financial report and to have it audited (Directive 89/666 /EEC).

Representative offices

A representative office, like a branch, is established by entry in the company register. However, a representative office may not engage in business activities, its business is limited to marketing and advertising for headquarters. This includes tasks related to the mediation, preparation and conclusion of contracts as well as information to and communication with business partners.

Given that the representative office may not carry out economic activities, it does not qualify as a Hungarian taxpayer, so it is not liable for corporate income tax or VAT. However, the foreign parent company still has the possibility to reclaim Hungarian VAT if it is based in the European Union (EU), or if there is a VAT treaty between Hungary and its home country. Otherwise, the parent company may also register as a VAT subject in Hungary and reclaim VAT over its Hungarian VAT-number.

So far as employment issues are concerned, the staff of the representative office are legally employed by headquarters under the application of Hungarian labor law, tax and social security rules.

What are the PROS (+) and CONS (-)?

As we have seen above, subsidiaries and branch offices are legal entities that conduct business, while the activity of representative offices is limited to marketing and advertising. Due to the lack of business activity, representative offices do not qualify for comparison with the other two business entities. The main pros and cons of subsidiaries and branch offices are as follows:

Liability:

• PRO (+): A subsidiary has limited liability, protecting headquarters from legal, tax and government compliance obligations.
• CON (-): In the case of a branch office, the foreign parent company will have full liability in Hungary, including legal, tax and government compliance obligations.

Oversight:

• PRO (+): A branch office can implement management decisions, processes and systems directly from headquarters.
• CON (-): The oversight of a subsidiary takes place indirectly through local management and under local regulations.

Compliance:

• PRO (+): A branch office in Hungary can in many cases benefit from less stringent local regulations, also pertaining to financial reporting. Practical administrative matters however are sometimes made more complicated due to the lack of precise guidance.
• CON (-): A subsidiary is obliged to maintain a full compliance system, including its own permits and agreements, abide by capitalization rules and other governmental obligations.

Cost:

• PRO (+): A branch office can generally be established and operated with lower cost, because its activity is usually limited and it is part of the parent company infrastructure.
• CON (-): Subsidiaries tend to have a more diverse business activity and generally also higher operational and compliance costs.

Credibility:

• PRO (+): Subsidiaries may have easier access to bank loans and investors not just in the country of operation, but also in the country of headquarters.
• CON (-): Branch offices are often not transparent enough for local banks.

Tax Risk:

• PRO (+): The limited liability of subsidiaries applies also to task risk.
• CON (-): Branch offices open a wider window for tax risk, not just because of the joint liability of the branch and the parent company, but also because the two states involved sometimes have divergent views on the implementation of double tax treaty rules. On the other hand, the quite specific application of double tax treaties and transfer prices may allow for tax savings, preceded by careful tax planning.

Political Exposure, Corporate Social Responsibility:

• PRO (+): Subsidiaries are usually only exposed in their country of operation.
• CON (-): Branch offices generally induce a wider exposure, because headquarters and the branch are usually liable in both of their legislations. On a general note, branches may however be exempt from foreign (third) country sanctions in the country where they operate.

Conclusion

Whether a company wishing to invest in Hungary does so by founding a subsidiary or a branch office depends greatly on its industry and the goals it wishes to pursue. Several arguments speak for both forms of operation, and for an optimal choice all aspects are to be carefully considered. A due diligence may be used to shed light on the advantages that each type of entity has to offer and help management make a well-founded decision.