The Rise of the Mortgage Investment Corporation: A hit 40 years in the making

Note to readers: This article provides some basic information about mortgage investment corporations and their history, and discusses some of the basic tax rules related to them. It is not intended to provide advice about investing in a mortgage investment corporation, nor is it intended to be used as a basis for setting one up.

The mortgage investment corporation (MIC) was created in 1973 as part of the Residential Mortgage Financing Act. At the time of its creation, Parliament believed a housing crisis was coming. With population growth in Canada expected to generate the need for an estimated 2.4 million new homes by 1981, it was estimated that $5 billion of mortgage financing would be required annually for new housing. Mortgage financing for new housing in 1970 was only $2.7 billion[1]—this meant that Parliament was looking at an annual gap of $2.3 billion.

Mortgage rates had climbed from 7% in 1965 to in excess of 10% in 1973, and it was evident that the increase was going to continue. North America was entering a period of inflation spurred on by an increase in consumer spending, an unprecedented increase in government spending, and the first round of OPEC oil price shocks. Conventional mortgage lenders were tightening their lending requirements. Where would the additional $2.3 billion of mortgage financing for new houses come from?

The rationale

Parliament created MICs to increase mortgage funds to finance the construction of new homes by accessing the accumulated wealth of the “small investor,” RRSPs, and pension funds. Parliament intended for MICs to help small investors overcome the following hurdles:

• Not being able to invest in residential mortgages because these investments could not be divided into smaller pieces and sold to a number of small investors. An MIC would permit small investors to invest an amount that represented a fraction of a mortgage.
   
• Not having enough money to invest in a diversified mortgage portfolio. A MIC could hold a diversified portfolio of mortgages, enabling the small investor to essentially invest in a piece of each mortgage.
   
• Not having access to mortgage experts to pick the mortgage investments and manage the portfolio. A MIC would have professional management that cost less than the management overhead of a conventional mortgage lender.
   
• The lack of liquidity in mortgage investments. A MIC would hold a portion of its portfolio in cash, permitting a small investor to liquidate as required.
   
• The double tax of a corporation. A MIC would not pay corporate income tax. Instead, the taxable income would flow through to the shareholder. It was thought that the lack of corporate income tax would make the MIC so attractive to RRSPs and pension funds that an additional $500 million in mortgage funds would make its way to the market annually.

The rules

Although created as part of the Residential Mortgage Financing Act, the MIC is actually a creature of the Income Tax Act (ITA). The following is a summary of the rules for MICs, as per section 130.1 of the ITA:

• A MIC must be a Canadian  corporation throughout the year.
• A MIC’s only activity is investing funds belonging to the corporation. At no time is a MIC a real estate developer or property manager (there is an exception for properties held by a MIC as a result of a foreclosure).
• A MIC cannot lend funds secured by real or immovable property located outside of Canada. (A MIC can lend funds to a non-resident person provided the loan is secured by real or immovable property located in Canada.)
• A MIC cannot own shares of a non-resident corporation (it can own shares of a Canadian corporation).
• At no time can a MIC own real or immovable property located outside of Canada or own a leasehold interest in such property.
• A MIC has special rules about the priority of dividends on preferred shares.

In addition, a MIC must have at least 20 shareholders throughout each taxation year (in its first year, the 20 shareholder test must be met on the last day of the year). No shareholder of a MIC can be a “specified shareholder,” as defined in subsection 248(1) and as modified in paragraph 130.1(6)(d) of the ITA.

This article cannot go into all of the rules regarding specified shareholders, but unique to a MIC is the fact that a shareholder can own, directly or indirectly, up to 25% of the issued shares of any class of the company’s capital stock (usually the threshold is 10%). When determining the 25% threshold, a shareholder is considered to own shares of the MIC owned by the individual’s child under the age of 18 and by the individual’s spouse or common-law partner (usually the definition is more broad, including persons connected by blood relationship, marriage, common-law partnership, or adoption).

There are specific rules about the investment mix for a MIC as well, and rules that limit borrowing based on the cost of the MIC’s assets and dependent on its asset mix.

The income earned by a MIC can flow through to its shareholders without being taxed in the MIC, thus avoiding the tax leakage of a corporation. The condition is that the MIC must pay a taxable dividend representing its taxable income for the year within 90 days of its year-end. Dividends received from a MIC are taxed in the hands of the shareholder as interest income.

Until the application of the “prohibited investment” and “advantage” rules was expanded from TFSAs to “registered plans” as a result of the 2011 federal budget, shares of a MIC were considered a “qualified investment” for registered plans even if the annuitant under the plan owned 25% of the shares of the MIC, provided: a) they did not offend any of the modified specified shareholder rules, and b) the MIC had not, at any time in the calendar year, lent funds to a “connected person.”[2] With the application of the prohibited investment and advantage rules, the shares of a MIC may still be a qualified investment for registered plans (these rules did not change); however, the annuitant will face significant penalty taxes if they have a significant interest[3] in the MIC. Simply put: “Significant interest” means the annuitant cannot own, directly or indirectly, at any time in the year, 10% or more of the issued shares of any class of a MIC’s capital stock (“directly or indirectly” includes shares owned by non-arms-length persons, trusts, partnerships, corporations, etc.).

A sudden rise in popularity

MICs were put in place in 1973 to prevent a perceived housing crisis because Parliament believed there would not be sufficient access to mortgage financing in the coming decade. But MICs did not become widely popular. Perhaps the small investor of the 1970s and early 1980s was not enamoured with the idea of investing in mortgages when five-year term deposits were paying anywhere from 6.67% in 1973 to as high as 17.5% in 1981 (it wasn’t until the mid-1990s that five-year term deposits began paying less than 6%). Maybe it was because real estate investment trusts, introduced in Canada a year prior to the MICs, better met the needs of the small investor.

It is only in the last few years that MICs have exploded in popularity. This could be because MICs are paying between 5% and 10% (some even higher) depending on the type of mortgages being put in place. There are presently more than 300 MICs in Canada,[4] with some of the largest having been around for less than 10 years. It’s possible that this has less to do with sudden popularity among small investors, per se, and more to do with popularity among sophisticated investors who are comfortable with the inherent investment risks of MICs and see few better options in the market right now.

In the end, it would appear that Parliament finally got what it wanted—albeit 40 years later—because MICs are now flowing substantial mortgage funds into the market. Too bad this is happening at a time when the Government of Canada and the Bank of Canada have expressed serious concerns about mortgages from conventional lenders being too cheap and too readily available.

Tom Morton is a tax partner with Smythe Ratcliffe in Vancouver and a long-standing member of the Canadian Tax Foundation.

Footnotes

1. Canada. Parliament. House of Commons. Debates, 29th Parliament, 1st session,  vol. 5, 1973 (pages 4684-4694).
2. Regulations 4900(1)(c) and 4901(2) of the Income Tax Regulations.
3. Subsection 207.01(4) and section 248(1) of the Income Tax Act.
4. Barry Critchley, “Yield draws investors to MICs,” Financial Post, November 14, 2012.