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Investment driven by preferential tax policies is flocking to Hainan. But should tax incentives be Hainan’s major attraction?

By NewsChina Updated Oct.1

Since China announced Hainan would become a free trade port with preferential tax and customs rules, businesses have flocked to the southern island, until recently better known as a vacation destination.  

In the year to May 31, 375,000 market entities were established in Hainan Province, a rise of 44.3 percent over the previous year, increased interest coming after China revealed in June 2020 that the entire island would become a free trade port (FTP). Between 2018, when it became a free trade zone, and March 2021, 763,000 companies were registered in Hainan, exceeding the total for the 30 years between 1988 and 2017, according to Hainan Provincial Market Supervision Administration.  

Investors are largely attracted by tax incentives. Corporate income tax can be as low as 15 percent, subject to certain conditions, compared with the 25 percent benchmark in the country. The Hainan FTP Law took effect on June 10, which means Hainan can tailor its own laws and regulations, including tax rates and rules, to facilitate trade and investment within its jurisdiction.  

However, the Hainan FTP master plan makes it clear that it will not become a tax haven. “Hainan FTP should build a risk prewarning and control system to prevent and reduce risks,” is written into the Hainan FTP Law. “We are determined to prevent Hainan from becoming a tax haven,” Feng Fei, Hainan governor, insisted during a briefing at an event in Beijing in June to mark the one-year anniversary of Hainan FTP.  

Preferential Tax 
From January 1, 2020, enterprises registered in Hainan may be subject to a corporate income tax (CIT) rate of 15 percent. To be eligible for the lower CIT rate, the main business of the enterprise must fall within the Encouraged Sectors list revealed in January. Also, the main business of the enterprise must contribute at least 60 percent of the enterprise’s total revenue, and the enterprise has to be in “substantive business operation” as defined by the official documents. By 2025, when the island will independently control its own customs operations, the policy will cover all enterprises outside a negative list registered in Hainan and engaged in substantive business activities.  

The standards of the “substantive business operation,” noted Carol Cheng with KPMG China Tax Center, are “not new, but have long been implemented both in China and internationally.” The company’s management body must reside in Hainan and have real control over the operation, personnel, accounting and assets of the company. Major decisions have to be made by executives on the island. “It is international common practice,” said Cheng.  

In building key industrial parks, local authorities in Hainan also made extra promises of cash rewards, subsidies and financial returns. In May 2020, Haikou, capital of Hainan, released preferential policies to attract the film and TV industry. If registered in Haikou, such companies will get their CIT and value-added tax 100 percent reimbursed and an extra reward of between 1 million yuan (US$154,300) and 4 million yuan (US$617,200) based on their tax contributions.  
No to Shell Companies 
The appealing tax policies, while drawing investment to the island, have raised concerns that it could become a tax haven for shell companies.  

Statistics from Tianyancha, a business data platform, show that in the first five months of 2021, in total 1,600 film and TV companies were registered in Hainan, a yearon-year increase of 653 percent. In the 12 months since June 2020, on average nearly 200 TV and film companies were registered per month, many financed by pop stars, including 25-year-old Wang Yibo, who was on Forbes China’s annual 30 Under 30 list 2019 that honors “young visionaries.”  

It is reminiscent of Horgos, a small remote city in Xinjiang Uygur Autonomous Region, which became a tax haven when preferential tax policies for the entertainment industry were offered in 2010. When companies registered in the city, CIT was exempt for the first five years and halved for the next five. Many companies, including those in the film and TV industry, swarmed to the city. Many were shell companies. When the city began to tighten its policies in early 2018, thousands of companies left.  

The central government apparently does not want to see this happen again in Hainan, or anywhere else in the country. Kenneth Leung, KPMG supply chain tax leader, told NewsChina that traditional tax havens, such as the British Virgin Islands, choose this path due to their conditions. They lack resources to develop their own growth engine. By attracting investment from around the world with zero corporate tax, they attract business service providers, particularly lawyers and accountants, who contribute to the local economy with their personal income tax and consumption. “But behind Hainan Province is China’s huge economy as a whole. Making Hainan a tax haven would be unfair to other provinces, which is what the central government wants the least,” Leung said.  

Hainan government is ensuring the tax policy is applied properly. Feng, the governor, said the government has reinforced supervision and is establishing a risk identification mechanism to cover companies in all industries beginning with registration. Local governments are required to clarify to enterprises the threshold for preferential tax eligibility and are prohibited from granting support policies directly related to corporate tax. “Next we will improve the inspection and supervision system and information sharing as well as learning from international experience in anti-tax avoidance,” Feng said at the June briefing.  

Staff disinfect duty-free goods to be mailed to buyers at a China Post delivery center branch in Haikou, Hainan Province, March 4

People wait to enter a duty-free center in Haikou, Hainan Province, January 31

Other Incentives 
The finance ministers of the G20, the group of the world’s 20 major economies, announced on July 1 that 132 tax jurisdictions, including China, have agreed to endorse a global minimum effective CIT rate of at least 15 percent.  

This consensus means that tax jurisdictions with a lower than 15 percent rate will face pressure to increase their CIT rate, and those offering tax incentive policies which may reduce the effective tax rate to less than 15 percent may no longer be as attractive to investors. 
As such, provided the minimum effective CIT rate does not go higher, Hainan should be fine to set its preferential rate at 15 percent. In addition, Hainan is not an independent tax jurisdiction. Taking into consideration the higher CIT rates of other regions in the Chinese mainland, the average effective tax rate of a group of companies headquartered in the mainland is likely to be 15 percent or higher. In this sense, Hainan’s preferential CIT rate of 15 percent may not see much impact from the new global consensus, according to Jean Li, EY Hainan Tax Services Leader. 

She believes it is too soon to confirm that many companies chose to register in Hainan just to take the advantage of the lower CIT rate. She told NewsChina that it does not make sense for a company to send one or two people to Hainan without earning substantial operational revenue there. It takes time for any business to grow. And for TV and film companies, for example, Hainan provides wonderful locations and a more convenient transportation network than Horgos.  

In addition, certain products attract zero import taxes or lower import taxes in some areas on the island. These favorable importrelated taxes will be extended to cover more products and to the whole island in 2025 when the new customs regime kicks in. Li said that investors, particularly foreign investors, are very interested in the favorable tax policies related to imports, so companies decided to register in Hainan to benefit from later preferential policies when the whole island is covered.  

In late July, the Ministry of Commerce (MOFCOM) released the country’s first negative list for cross-border trade in services that will be implemented in Hainan FTP, which specifies 70 special administrative measures for 11 sectors including finance and education. Domestic and foreign service providers shall enjoy equal market access to sectors off the list on the island, with greater openness and transparency and predictability, according to MOFCOM.  

There are only four years until the new rules come in 2025. More detailed rules and policies to implement the law and the master plan are expected to be formulated and announced in the next two or three years. Leung believes there could be steps toward more openness in other sectors, such as energy and telecommunication, and that these will be more important for competitiveness in Hainan. In this case, Hainan will be perceived as an attractive destination for global investment compared with the two major well-developed FTZs around it, the Hong Kong Special Administrative Region and Singapore.