A mortgage investment corporation (“MIC”) and its shareholders are entitled to special tax treatment under section 130.1 of the Income Tax Act (Canada) (the “Act”). These special rules were introduced to attract more money to the Canadian mortgage market for residential financing, which is a growing multi-billion dollar industry in Canada.
Pursuant to these special rules, the income received or receivable by a MIC is effectively only taxed at the shareholder level by allowing the MIC to deduct taxable dividends paid to its shareholders, other than capital gains dividends, and by treating such dividends as interest in the hands of its shareholders.
Qualifying as a MIC Under the Act
A corporation involved in the Canadian mortgage market will qualify as a MIC if it meets all of the conditions set forth in subsection 130.1(6) of the Act. Certain of these conditions are discussed below.
A MIC must be a Canadian corporation (within the meaning of the Act) and its only undertaking must be the investing of its funds. MICs are specifically prohibited from 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, sale agreements 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.
In these circumstances, it may be necessary for a MIC to provide certain management and administrative 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.
These management and development activities could jeopardize the MIC’s status for special tax treatment under the Act leading to unintended and potentially disastrous consequences for the MIC and its shareholders. The Canada Revenue Agency appears to have adopted an unfavourable interpretation of the Canadian tax rules which may cause some MICs to be subjected to greater scrutiny on a go forward basis.
There is a potential solution to this issue provided that certain legal relationships are properly created and maintained. A MIC that may be at risk of being involved in 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
to closely monitor the various criteria set forth above during the operation of the MIC in order to ensure that the rules are met at all times.
A MIC is also precluded from holding certain properties including debts owing to the MIC that were secured on real property situated outside of Canada, debts owing to the MIC by non-resident
persons except any such debts that were secured on real property situated in Canada, shares of the capital stock of corporations not resident in Canada or real property situated outside Canada, or any leasehold interest in such property.
The MIC must have at all times 20 or more shareholders, none of which may own alone or together with related persons in excess of 25% of the issued shares of any class of the capital stock of the MIC. In the first taxation year of the MIC, these requirements are somewhat relaxed and will be considered to be met throughout the year to the extent they are met at the end of the MIC’s first taxation year.
At all times, in excess of 50% (computed based on the cost amount (within the meaning of the Act) to the MIC of all its assets) of the assets of the MIC must be invested in Canadian residential mortgages or in deposits held in the Canada Deposit Insurance Corporation, insured institutions or credit unions. Certain debt/equity ratios must also be maintained by the MIC at all times.
Failure to satisfy all of the requirements included in subsection 130.1(6) of the Act will result in the loss of the special tax advantages related to the MIC status under the Act.
MIC Shares Eligible Investments for Deferred Income Plans
MICs are generally authorized to issue common and preferred shares. Usually, a MIC issues redeemable preferred shares to its shareholders with fixed dividend rates.
Shares of a MIC will generally be “qualified investments” for deferred income plans including registered retirement savings plans (“RRSPs”), registered retirement income funds (“RRIFs”), tax-free savings accounts (“TFSAs”), deferred profit sharing plans (“DPSPs”), registered education savings plans (“RESPs”) and registered disability savings plans (“RDSPs”) (collectively, “Deferred Plans”) provided that the MIC does not hold as part of its property at any time during the particular calendar year any indebtedness, whether by way of mortgage or otherwise, of a person who is an annuitant, a beneficiary, an employer or a subscriber under, or a holder of, the Deferred Plan and any person who does not deal at arm’s length with such person. In essence, this prohibits a MIC from holding a mortgage on residences of the shareholders of the MIC.
An investment in an MIC is particularly attractive for these types of Deferred Plans because the MIC is generally not subject to tax nor do the Deferred Plans pay any tax on the interest they are deemed to receive. However, holders of TFSAs and annuitants of RRSPs or RRIFs may be subject to certain penalty taxes if the investment in the MIC is a “prohibited investment” for purposes of the Act.
A MIC is also an attractive investment vehicle for Deferred Plans because currently the Canadian tax rules prohibit Deferred Plans from borrowing funds. Deferred Plans are therefore restricted to earning income on funds contributed to them. Deferred Plans can enhance their income generating capability by leveraging their available capital through investments in a MIC.
Furthermore, although holders of Deferred Plans may wish to invest in mortgages, unless there is a considerable amount of money in the Deferred Plans, they will generally only be able to invest in one or two small mortgages at best. Such holders will be able to access larger pools of capital and invest in a significant number of mortgages through an investment in a MIC thereby reducing their risk by diversification.
As with any investment that involves residential mortgages, there are several risk factors to be considered. 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, 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).