A General Overview
A mortgage investment corporation (“MIC”) is a type of corporation that is entitled to special non-taxable status (as a conduit for flowing interest income earned on residential mortgage loans to its shareholders) under Section 130.1(6) of the Income Tax Act (the “Act”).
Canada Revenue Agency’s (“CRA”) philosophy behind this special tax status is simple: it has deemed it appropriate, in its wisdom, to attract more money to the Canadian mortgage market for residential financing, which is a growing multi-billion dollar industry in Canada. Therefore, CRA will not tax a MIC, provided however, it adheres to all of the special rules contained in Section 130.1(6) of the Act.
The shares of the MIC are an “eligible investment” for deferred investment plans, including: registered retirement savings plans (“RRSPs”), registered retirement income funds (“RRIF”), tax free savings accounts (“TFSA”), life investment funds (“LIF”), locked-in retirement accounts “(LIA”), individual pension plans (“IPP”), registered educational savings plans (“RESP”) and registered disability savings plans (“RDSP”) (collectively, “Registered Plans”). An investment in an MIC is particularly attractive for these types of Registered Plans. This is because the MIC does not pay any tax when its income is flowed out as dividends, nor do the Registered Plans pay any tax when they receive the dividends. The beneficiaries of the Registered Plans do not pay tax until they collapse their Registered Plans and actually receive the funds directly therefrom.
Shares of a MIC are usually “qualified investments” for all Registered Plans. However, shares in an MIC will be disqualified under the Act, as an investment for any of these Registered Plans, to the extent that any time during the year the MIC holds, as part of its property, a mortgage from or other indebtedness of a person who is an annuity beneficiary, or an employer under the Registered Plan, or another person who does not deal at arm’s length with such person, the net effect of this provision of the Act is to prevent funds of a Registered Plan from being available in any way for the benefit of an annuitant, beneficial or employer under a Registered Plan or any person not dealing at arm’s length with them. In essence, this prohibits a MIC from holding a mortgage on residences of the shareholders of the MIC.
A MIC is also an attractive investment vehicle for Registered Plans because currently the Canadian tax rules prohibit Registered Plans from borrowing funds. Registered Plans are therefore restricted to earning income on funds contributed to them. Therefore, through holding shares in a MIC, Registered Plans can enhance their income generating capability by leveraging their available capital.
Furthermore, although Registered Plan holders may wish to invest in mortgages, unless there is considerable amount of money in their plans, they will only be able to invest in one or two small mortgages at best. Through investing in a MIC, there becomes available a very large pool of capital. Therefore, Registered Plan holders can invest in a number of mortgages, thereby reducing the risk by diversification.
It is quite normal for Registered Plans to achieve rates of return in a range of between 9-14%, or sometimes a bit more, compounded, through investing in MICs. The potential accumulation of funds through Registered Plans using such a high compound interest rate is very dramatic.
As with any investment undertaking that involves residential mortgages, there are several risk factors. Many of these risk factors can be minimized by employing an effective mortgage portfolio manager or credit/risk committee and establishing very strict lending parameters and ardent policies and procedures for granting mortgage loans, based on the underlying value of the security (i.e., restricting mortgages to a maximum of say 75%-80% of fair market value of the property (based upon current local market appraisals).
In summary, the special tax rules permit a MIC to obtain tax deductions for the dividends it pays and these will be fully taxable to the recipient. But, if the recipient is the Registered Plan, the receipt will be tax deferred in the Registered Plan until withdrawal. The result can be a very attractive after-tax rate of return on investment.
The MIC must have at all times greater than 20 shareholders, none of which may own in excess of 25% of the share capital of the MIC. In the first taxation year of the MIC, these requirements are relaxed somewhat and will be considered to be met throughout the year to the extent they are met at the end of the taxation year.
The articles of incorporation of a MIC can have both preferred shareholders and common shareholders. Usually, a MIC issues redeemable preferred shares to its investors, with fixed dividend rates.
At all times, in excess of 50% of the assets of the MIC must be invested in Canadian situs, residential mortgages or in deposits held in Canada Deposit Insurance Corporation, insured institutions or credit unions.
Certain debt/equity ratios must also be maintained by the MIC at all times, as follows:
- To the extent that at least 50% and less than two-thirds of the property, measured at its tax cost, is held by the MIC in residential mortgages and in insured deposits, a three-toone debt to share equity ratio, at maximum, is allowed; and
- In those situations where in excess of two-thirds of the cost, on a tax basis, of the property of the MIC is invested in residential mortgages or insured deposits, a five-toone debt to share equity ratio maximum is acceptable.
Failure to satisfy all of the above requirements will result in a MIC failing to qualify as a MIC for income tax purposes, thereby losing all of the favourable tax advantages of this particular status under the Act.
There is also a prohibition against MICs “managing or developing” real property. In some instances, mortgagors under certain mortgages held by a MIC will default, resulting in the MIC ultimately becoming the beneficial owner of the mortgaged property by way of foreclosure proceedings, by way of agreement for sale or otherwise. These foreclosed or impaired properties may be occupied, either by a foreclosed mortgagor in possession or by tenants under a tenancy agreement, or simply be unoccupied. It may be necessary for a MIC to provide certain “management and administration services” and assist with the development (or renovation) of the real properties at issue. MICs may have to collect rents, make significant repairs to comply with certain residential tenancies legislation and also bring the real properties into a saleable condition for prospective buyers.
The aforementioned “management and development” activities could jeopardize the MIC’s status as a “MIC” pursuant to subsection 130.1(6) of the Act leading to unintended and potentially disastrous consequences for the MIC and its investors. The CRA appears to have adopted an unfavourable interpretation of the rules, and recent tax law changes affecting some MICs may cause some MICs to be subjected to greater scrutiny on a go forward basis.
There is a unique solution to this issue, provided however that certain legal relationships are properly created and maintained. A MIC that may be at risk of being involved in the aforementioned “management, administration and development activities”, may be able to rely on certain deeming rules in the Act which will allow it to remain in compliance with paragraph 130.1(6)(b) in subsequent taxation years. It is essential that one closely monitors the various criteria set forth above during the operation of the MIC in order to ensure that the rules are met at all times.