The Substantive Operation Standards in China’s Hainan Free Trade Port: Development, Application, and Effectiveness /Zheng Xinyue

The Substantive Operation Standards in China’s Hainan Free Trade Port:  Development, Application, and Effectiveness /Zheng Xinyue

1. Introduction 

The development of tax incentives and anti-avoidance rules in Hainan Free Trade  Port (FTP) reflects China’s aim to build a competitive free trade and investment hub  while strengthening regulatory oversight. Since its launch in 2018, Hainan has sought  to attract multinational enterprises, develop high-tech and modern service industries,  and integrate more closely with global economic governance. To ensure that the FTP’s  preferential tax regime aligns with international tax standards, especially those under  the OECD’s Base Erosion and Profit Shifting (BEPS) framework, China has  incorporated substantive operation requirements into Hainan’s tax policies. 

Internationally, economic substance rules emerged to counter harmful tax  competition and profit shifting.¹ BEPS Action 5 introduced the “substantial activity  requirement” that reshaped IP box regimes through the “nexus approach,” linking tax  benefits to domestic R&D, and required non-IP regimes to demonstrate adequate  expenditure, employees, and assets.² Low-tax jurisdictions such as the Cayman Islands,  Bermuda, and BVI adopted Economic Substance Acts in response.³ Regionally, the EU  has advanced similar objectives.⁴ ATAD 3 proposes “substance indicators” to identify  shell entities, focusing on business premises, staff, and active management.⁵ These  actions further impact the development of China’s Hainan FTP substantive operation  requirements. 

¹ The BEPS Action 5 published for multinationals shift profits to low or no-tax locations where they have little or  no economic activity, which costs countries USD 100-240 billion in lost revenue annually, see OECD, Base  Erosion and Profit Shifting, https://www.oecd.org/en/topics/base-erosion-and-profit-shifting-beps.html (Last  visited Nov. 29, 2025). The prevention of harmful tax practice based on substance was also reaffirmed in the latest  United Nations Ad Hoc Committee on International Tax Cooperation, Co-Lead’s Draft Framework Convention  Template (2025), Art 8. 

² See OECD, Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and  Substance, Action 5 - 2015 Final Report, OECD Publishing, 2015. 

³ See Cayman, International Tax Co-operation (Economic Substance) Law (2018); BVI, Economic Substance  (Companies and Limited Partnerships) Act (2018). Some jurisdictions also applied substantive standards in their  Specified Foreign-sourced Income (FSIE) treatment in response to the compliance burden from the EU and  OECD, see Hong Kong, Inland Revenue (Amendment) (Taxation on Specified Foreign-sourced Income)  Ordinance (2022); Hong Kong, Inland Revenue (Amendment) (Taxation on Foreign-sourced Disposal Gains) Bill  (2023); Singapore, Income Tax (Amendment) Bill 2023; IRAS e-Tax Guide, Tax Exemption for Foreign-Sourced  Income (Fourth Edition), IRAS Publishing, 2023. 

⁴ See Chidozie Chukwudumogu, The Regulation of Tax Competition: Rethinking “Harmful” Tax Competition in a  Global Context, Edward Elgar Publishing, 2021. 

⁵ See Proposal for a Council Directive laying down rules to prevent the misuse of shell entities (Last visited Nov.  1, 2025), https://www.pwc.com/mt/en/publications/tax-legal/the-unshell-directive.html.

1 

Research Survey Zheng Xinyue 12920241150806 

2. Application Requirements of Substantive Operation Standards in Hainan FTP Hainan’s preferential tax regime centers on a reduced 15% corporate income tax  (CIT) rate for enterprises in encouraged sectors such as tourism, modern services, high tech industries, and innovation-driven manufacturing. The core legal instruments  governing substantive operation requirements include: (1) Hainan FTP Overall Plan  (2020) and the MOF and STA Circular [2020] No. 31 on Preferential Corporate Income  Tax Policies in Hainan FTP, which establishes the 15% CIT rate and mandates that  beneficiaries demonstrate substantive operations in Hainan, a requirement reiterated in  Hainan Tax Service Announcement [2020] No. 4.⁶ (2) Announcement No. 1 (2021)  jointly released by three Hainan Provincial Departments on Issues Related to the  Substantive Operations of Enterprises in Industries Encouraged by the Hainan FTP,  which specifies four elements that constitute substantive operations and details the  requirements in application of these policies in different scenarios. Under these rules, enterprises must meet four substantive operation criteria: (1)  Operational Substance. Core income-generating functions must occur in Hainan, and  the enterprise’s principal business must have a real and continuous presence there. (2)  Personnel Requirements. The company must employ an adequate number of staff in  Hainan, with management and decision-making functions conducted locally. (3)  Accounting Presence. Key financial books and records must be kept within Hainan to  ensure transparency and facilitate tax audits. (4) Property and Asset Substantiation. Essential business premises, equipment, and relevant assets must be located or  registered in the FTP to demonstrate real operational capacity. 

3. Effectiveness and Future Prospects 

Hainan’s substance-based approach has effectively aligned its tax incentives with  international standards. The incorporation of substantive operation requirements  significantly reduces the risk that the regime will be characterized as a harmful tax  practice under BEPS Action 5 or face external scrutiny.⁷ The requirements also help  

⁶ The 15% preferential tax rate and the substantive operation requirements are further extended to Dec. 31, 2027,  see: Hainan Provincial Tax Service, STA, Interpretation of the STA Hainan Announcement on Issues Concerning  the Continuation of the Preferential Policies for Corporate Income Tax in the Hainan FTP,  https://hainan.chinatax.gov.cn/ssxc_3_5_2/14160626.html (last visited Nov. 29, 2025). 

⁷ Frederik Heitmuller, Irma Mosquera, Special Economic Zones Facing the Challenges of International Taxation:  BEPS Action 5, EU Code of Conduct, and the Future, Journal of International Economic Law, 2021, Vol. 24, No.  2, pp. 473-490.

2 

Research Survey Zheng Xinyue 12920241150806 

attract enterprises willing to establish genuine operations, contributing to sustainable  economic development rather than facilitating shell entities. 

However, challenges remain. First, uniform substance tests across industries do not  adequately reflect the realities of digital-intensive or service-based sectors, where  physical assets and local employees may be less central. Second, the rise of remote,  digitalized operations complicates the verification of genuine activity and increases  administrative burdens on tax authorities. Third, Pillar Two’s 15% global minimum tax  introduces additional pressures. While Hainan’s headline CIT rate complies, certain  preferential mechanisms, especially IP-related incentives, may reduce effective tax  rates below the threshold, triggering top-up taxes in other jurisdictions.⁸ 

Looking forward, Hainan may enhance its effectiveness by: (1) Adopting industry specific, risk-based substance requirements, tailoring criteria to digital services, biotech,  manufacturing, and tourism. (2) Using formulaic, verifiable indicators such as payroll  ratios, asset thresholds, or local expenditure requirements that aligned with Pillar Two ’s substance-based carve-outs. (3) Institutionalizing substantive operation  standards within China’s broader anti-avoidance framework to ensure consistency  with general tax administration rules. (4) Diversifying incentives beyond reduced  rates, including additional deductions for R&D, targeted grants, and enhanced  infrastructure and talent support. 

⁸ Chen Jingxian, Global Minimum Tax Reform's Influences on China's Tax Incentives Regime and Response  Measures, 2023, International Law Research, Vol. 5, pp. 101-119 (陈镜先：《全球最低税改革对中国税收优惠制 度的影响与应对》，载《国际法研究》2023 年第 5 期，第 101-119 页); Qiu Dongmei, Some Thoughts on  Legislative Changes in Various Countries Triggered by the Global Minimum Taxation and China’s Response (Part  3), 2024, International Taxation, Vol. 4, pp. 32-39 (邱冬梅：《全球最低税引发的各国立法变革及我国应对之若 干思考（下）》，载《国际税收》2024 年第 4 期，第 32-39 页)。

3 

Research Survey Zheng Xinyue 12920241150806 

References 

[1] United Nations Ad Hoc Committee on International Tax Cooperation, Co-Lead’s  Draft Framework Convention Template (2025). 

[2] OECD, Countering Harmful Tax Practices More Effectively, Taking into Account  Transparency and Substance, Action 5 - 2015 Final Report, OECD Publishing,  2015. 

[3] Chidozie Chukwudumogu, The Regulation of Tax Competition: Rethinking  “Harmful” Tax Competition in a Global Context, Edward Elgar Publishing, 2021. [4] Proposal for a Council Directive laying down rules to prevent the misuse of shell  entities (Last visited Nov. 1, 2025), https://www.pwc.com/mt/en/publications/tax legal/the-unshell-directive.html. 

[5] Chen Jingxian, Global Minimum Tax Reform's Influences on China's Tax  Incentives Regime and Response Measures, 2023, International Law Research, Vol.  5, pp. 101-119 (陈镜先：《全球最低税改革对中国税收优惠制度的影响与应 对》，载《国际法研究》2023 年第 5 期，第 101-119 页) 

[6] Qiu Dongmei, Some Thoughts on Legislative Changes in Various Countries  Triggered by the Global Minimum Taxation and China’s Response (Part 3), 2024,  International Taxation, Vol. 4, pp. 32-39 (邱冬梅：《全球最低税引发的各国立 法变革及我国应对之若干思考（下）》，载《国际税收》2024 年第 4 期，第 32-39 页)

4