With significant potential for favourable rates of return and previously instituted tax exemptions, Canadian Mortgage Investment Corporations (MIC’s) are increasingly becoming recognized as a low-risk method of investment. In 1972, the Residential Mortgage Financing Act was developed by the federal government to encourage private financing. The Act later functioned as a precursor to Section 130.1 of the federal Income Tax Act (ITA) which is responsible for setting out the “rules that apply to mortgage investment corporations and their shareholders”.[i]
MICs were first established to provide investors with the opportunity to invest their money as shareholders into residential mortgages, and to own a portion of the MIC’s total portfolio. As a result, MICs have become known for their great advantages such as the direct flow-through of net income to investors with the exemption of corporate tax.[ii] MIC’s invest primarily in residential mortgages however mortgages in commercial, industrial, developmental and construction categories are also customary. Considering how volatile the stock market can be, the MIC is an excellent option for investors, particularly those who are interested in something similar to mortgage note investing, to receive consistent dividends while owning security against real property.
Depending on the particular MIC, certain investment options such as RRSPs, RRIFs, DPSPs, or RESPs and TFSAs may be eligible for MIC investment, and distributions received on MIC investments held through these investment options are taxed according to their respective regulations.
MICs experience restrictions as well, such as the inability to invest more than 25% of all corporate assets in real estate, as well as the inability to develop land or engage in construction.[iii] Legislation exists to ensure that MICs are bound to a set of stated rules, such as the condition that MICs are to be held as a public corporation (according to the ITA at 130.1(5)). Subsection 130.1(6)(c) of the ITA lists certain criteria that a MIC must satisfy throughout a taxation year, including that none of the property of the corporation may consist of: (i) debts secured by real property situated outside of Canada; (ii) debts owing by non-residents unless secured by real property situated in Canada; (iii) shares of non-resident corporations; or (iv) real property situated outside of Canada or leasehold interests in such property. The corporation must be Canadian and no person may own, directly or indirectly, more than 25% of any class of shares. (ITA 130.1(6)(d)). In addition, at least 50% of a MIC’s assets must be in residential mortgages, and/or cash and insured deposits through the Canada Deposit Insurance Corporation member financial institutions (ITA 130.1(6)(f)(ii)(A)).
Provincially licensed mortgage brokers and real estate agents are typically accountable for the management of the MIC; this involves sourcing, acquiring and administering mortgages that would provide the greatest rate of return with the lowest possible risk. The mortgage portfolio is continuously managed with newly invested share capital and the proceeds from repaid and discharged mortgages are utilized to fund new mortgages. MICs typically include a Credit Review Committee of shareholders who are responsible for the review and approval or rejection of mortgage applications in the portfolio. This is to protect shareholders’ investments while remaining cognizant of current market conditions and any potential underlying risks. Since brokers gain commission from placing mortgages, they are restricted from acting as members of Credit Committees due to an obvious conflict of interest. At the end of every fiscal year, audits of a MIC’s annual financial statements must be made by an independent accounting firm.
In Ontario, MIC’s are registered and licenced provincially and must meet additional requirements to receive tax incentives pursuant to section 130.1 of the ITA. If all conditions expected of the MIC during the course of the year are met, the corporation receives entitlement to reduce its taxable income to the extent that taxable dividends are paid by the corporation during the year, or within 90 days post year-end (ITA 130.1(1)). Although taxable dividends received from the MIC are considered interest income, they do not qualify for any gross-up or dividend tax credit and are subject to full income inclusion by the shareholder (ITA 130.1 (2) and (3)).
The creation of a MIC is similar to other corporations in the method of organization, election of directors/officers and the faculty to appoint committees, hire employees, and issue shares. Generally, a MIC will authorize and issue several different classes of shares including common voting shares and preferred non-voting shares. The MIC itself will not pay income tax so long as the profits are flowed through to the shareholders and taxed in their hands. This is advantageous to an investor who has purchased MIC shares through a self-directed registered retirement savings plan (RRSP) or a self-directed registered retirement income fund (RRIF) as the tax is deferred until the funds are transferred or annuitized.[iv] In the case of Tax Free Savings Accounts (TFSA), the dividends earned are tax-free when withdrawn.[v]
The investment process begins when an investor deposits funds into the MIC, followed by the funds’ exchange in return for company shares. Each investor is entitled to an appropriate number of preferred shares, entitling the shareholder to a prorated share of mortgage income earned by the MIC. When investing in an RRSP, the investor instructs the trustee to deposit funds on their behalf into the MIC, and the trustee holds the preferred share certificate “in trust”. Projected returns range (depending on the MIC) from 6%-12% per year and are usually disbursed quarterly in the form of a dividend and taxed to the individual as interest income which can be received in cash or reinvested back into the MIC. Dividends may be collected by way of funds or additional shares (ITA, 130.1).
According to section 130.1 of the ITA, a MIC must distribute 100% of its annual net income before taxes to shareholders in the form of dividends. As is commonplace for any company, a MIC’s net income is equivalent to its revenues, minus expenses. Principal expenses include management fees, audits and other professional fees. Revenue is earned in the form of mortgage interest from fees, penalties, interest from mortgages, revenue from property holdings, and capital gain dividends, typically from the disposition of real estate investments (ITA, 130.1).
With all investments come potential risks and benefits, and while the risks of investing in a MIC are few, there are a few potential vulnerabilities to MICs one should be aware of prior to making a financial commitment. Although fraudulent occurrences are uncommon since MICs must produce audited financial statements each year, an investor can research to see if the MIC is subject to any lawsuits by reviewing its yearly financial statements. If a MIC fails to maintain status by eluding the ITA’s requirements, the MIC will have its income taxed prior to shareholder distribution, lowering returns significantly. Audited financial statements show investors how much the MIC has borrowed, and the prospectus typically shows what the MIC policy caps are for the borrow limits. (Many MICs are reasonably short term lenders, usually with a turnaround within 24 months).
A reasonable concern that investors may have regarding investing in MICs is “what if the mortgagor defaults?” Management of the MIC must be vigilant and selective with whom they lend to, and investors can inquire about whether the MIC in question will allow investments within various percentage brackets ranging from low to high risk. This option would provide investors with the opportunity to select an investment according to their level of risk (this option does exist with certain MICs). Also, investors that are researching potential involvement in MICs should be aware that there are some MICs in limited markets, such as smaller towns, that concentrate on specific industries. Considering the location, economy and possible market downturn is essential for investors to decide if they feel that risk is not an option.
Benefits of investing through a MIC are many, but not limited to: the excellent potential for dividend distribution, the extenuation of potential risk by the ample participation of investors, the adherence to legislative expectations by the MICs professional management team and the careful continuous consideration of the Credit Review Committee. Furthermore, shares are typically redeemable in certain prescribed circumstances and may be retracted at any time provided that the fund has the capital capacity to make the redemption. As aforementioned, an additional benefit to MICs is the security provided to investors with annual audits of financial statements to ensure accountability of finances and safety against fraud, including financial reporting to shareholders every month.
MICs provide an excellent alternative source of financing and for the many positive reasons discussed, MICs are growing exponentially in operation and capacity in Canada. With prudent and professional management, MICs can achieve high returns to investors with low risk. As with any investment, be it real property or by way of share purchasing, investors should discuss the legal operative requirements of a MIC with their lawyer when deciding to establish a MIC, or just to discern whether the ITA’s legal requirements are clearly abided by a MIC in order to make the most profitable yet secure investment decision. The lawyers at Levy Zavet PC can definitely assist investors in deciding to invest in a MIC on a compliance level, but also can help those looking to start and incorporate a new MIC, as well as advise on maintaining a MIC.
[i] Department of Finance Canada, “Explanatory Notes Relating to the Income Tax Act, the Excise Tax Act and Related Acts and Regulations: Part 5”, Clause 276 <http://www.fin.gc.ca/drleg-apl/nwmm-amvm-1012n-05-eng.asp>
[ii] Ottawa Citizen, “Mortgage Investment Companies Drawing Tentative Investor Interest” [Feb 21, 1976]
[iii] Justice Laws Website – Government of Canada, “ITA – Mortgage Investment Corporations”, [Mar 01, 2013] at S.130.1(5)(b) <http://laws-lois.justice.gc.ca/eng/acts/i-3.3/page-214.html>
[iv] InvestingThesis.com “A Primer on Investing in Mortgage Investment Corporations (MICs) In Canada” <http://www.investingthesis.com/analysis-insights/a-primer-on-investing-in-mortgage-investment-corporations-mics-in-canada/>