The Interest Act sets out mandatory prepayment rights for loans secured by mortgages on real property or hypothecs on immovables that have terms of more than five years. Section 10(1) of the act provides that any person who is liable or entitled to pay such a loan may prepay the full amount of the loan after five years, subject only to a penalty of three months of interest. Section 10(1) does not apply to a hypothec or mortgage granted by a corporation or securing a debenture issued by a corporation. Historically, borrowers have only been free to negotiate prepayment terms for mortgage loans directly with lenders where this exemption applied.
As Mr. Justice Robins of the Ontario Court of Appeal pointed out in the frequently cited case of Litowitz v. Standard Life, the Section 10 right of prepayment was first enacted by Parliament in 1880. It was intended to remedy the problem of farmers being locked into long-term mortgages at high interest rates and being subjected to large penalties when they sought prepayment. The exemption for corporations was enacted roughly 10 years later to allow corporations, particularly railway companies, to obtain long-term financing by way of loans secured by real estate. Section 10 of the Interest Act has not since been amended in any meaningful way and, with the evolution of finance and commerce, has become seriously outdated and an obstacle to commercial lending.
Because the provisions of the Interest Act are of public order and cannot be contracted out of, most lenders have, understandably, been reluctant to provide loans with a term of more than five years where the security for that loan is a hypothec or mortgage granted by an entity other than a corporation. Three months of interest simply is not adequate compensation to the lender for the "breakage" costs associated with prepayment of, for example, a 10-year loan after five years. It has become common for real estate to be held through vehicles such as partnerships, trusts or certain other "pass-through" entities for income tax, capital tax and other legitimate reasons. The prepayment right provided in the Interest Act has severely limited access of commercial borrowers who hold real estate through such vehicles to longer term loans, and indeed has required the adoption of complicated, expensive, and otherwise unnecessary, structures in order to provide access to longer term money.
Even when the hypothec is granted by a corporation, there has been uncertainty in Québec as to whether there is a right to prepay after five years where the corporation granting the hypothec is a prête-nom or nominee of a beneficial owner that is not a corporation. The Ontario Court of Appeal is generally thought to have resolved this particular issue for the common law provinces in the Litowitz case by deciding that individuals who held registered title to real estate through a nominee corporation were precluded from claiming Section 10(1) relief because they had chosen to conduct their affairs through a corporation. However, because of differences between the laws of Québec and the common law provinces, there has been considerable doubt as to whether the reasoning of the Litowitz decision would apply in Québec.
Thankfully, the federal government has at long last recognized that there are compelling reasons to make it possible for a wider variety of business entities to obtain long-term loans secured by real estate. After broad consultation with real estate stakeholders as to which business entities should be free to negotiate prepayment privileges on their own, the federal government has now published regulations that provide that the statutory prepayment right will not apply to mortgages of real property or hypothecs on immovables granted after January 1, 2012 by (i) partnerships, (ii) trusts settled for business or commercial purposes, (iii) Alberta unlimited liability corporations, (iv) British Columbia unlimited liability companies, and (v) Nova Scotia unlimited companies.
This is a welcome legislative reform that should allow most real estate investors to obtain long-term secured loans without having to restructure their real estate holdings to accommodate the anachronistic provisions of the Interest Act.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.