# Horizons ETFs in taxable accounts



## MarcoE (May 3, 2018)

Does anyone here invest in Horizons ETFs? Specifically HXT? What are your thoughts on Horizons and their funds?

Horizons ETFs are different than traditional ETFs from companies like Blackrock and Vanguard. Instead of holding bonds or stocks directly, they use a total return swap (TRS).

From Horizons' website: *A TRS is commonly used by large institutional investors. It is simply an agreement between investors and a large financial institution (the "counterparty") whereby the investors exchange (or "swap") their capital, which is held as cash in a custodial account, for the total return delivered by another asset such as a stock market index.*

The advantage: Horizons ETFs do not pay dividends to investors. Instead, the dividends are reinvested in the backend. For example, if a "regular" ETF would appreciate 5% in a year and pay 2% in dividends, a counterpart Horizons ETF would simply appreciate 7%. This can be useful in a taxable account, since dividends are taxable. This might be especially useful for small business owners, since dividends are taxed at 50% in business accounts.

I'm thinking of purchasing a Horizons ETF (HXT) for my taxable account. But I don't have too much experience with total return swaps. Is anyone here a swaps expert and can offer some thoughts?


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## andrewf (Mar 1, 2010)

Eligible dividends can be flowed through to the shareholders of a small business at zero tax.

I think these funds have a place. You have to keep in mind that they carry somewhat higher fees that offsets the tax benefit, particularly for taxpayers that aren't facing very high marginal rates. Some here are concerned about the counterparty risk. I am not too concerned about it, but there is some additional risk you should be compensated for taking.


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## AltaRed (Jun 8, 2009)

As a matter of principle, I try to avoid financially engineered products like the plague. Eventually, most such products bite the dust, either through tax legislation (like income trusts), or a financial crisis like 2008-2009. To me, it is the tax tail wagging the dog, albeit as HP will point out, there is a lot of securities lending occurring within everyday ETFs themselves to reduce MERs and/or juice distributions. 

Counterparty risk is related to the quality of the collateral being pledged in derivatives, how deep the pockets of the counterparties are, etc. We all know what happened with the likes of AIG in the USA during the financial crisis. Do you know what is under the hood with Horizon products?


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## MarcoE (May 3, 2018)

The problem I'm personally facing: Nearly my entire net worth is inside my small business. I have a portfolio there in a taxable account. The corporate tax rate on dividends & interest is 50%. Then, when I withdraw the money (e.g. as salary or dividends to myself), I pay personal taxes on that money too. The result is that my portfolio cannot properly compound. As soon as dividends come in (e.g. from an ETF like XBB), half are lost to the taxman. More of the money is lost when I withdraw it. The result: I'm only able to reinvest a minority of the dividends I earn, which is killing my portfolio's performance.

So I've been looking for solutions. One solution is to simply withdraw the entire portfolio into a personal account, but then I'd lose half to income taxes right away. Horizons ETFs is one possible solution I found. If they don't pay dividends, I can let my portfolio compound tax free, and withdraw only whatever money I need, when I need it. The capital gains tax inside a corporate account is much lower, only about 25%.

Any thoughts on other possible solutions? How can I protect my portfolio (inside a business account) from getting pummeled by a 50% tax?


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## MarcoE (May 3, 2018)

AltaRed said:


> Counterparty risk is related to the quality of the collateral being pledged in derivatives, how deep the pockets of the counterparties are, etc. We all know what happened with the likes of AIG in the USA during the financial crisis. Do you know what is under the hood with Horizon products?


I share your concerns, which is why I posted here, hoping to hear from somebody who might understand Horizons better than I do.


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## james4beach (Nov 15, 2012)

andrewf said:


> Eligible dividends can be flowed through to the shareholders of a small business at zero tax.


Might that solve MarcoE's difficulty? If the corporation holds XIC, with lots of eligible dividends, can those flow through to the shareholders instead of being heavily taxed inside the corp?

I'd imagine this is a common scenario for doctors, dentists, etc.


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## MarcoE (May 3, 2018)

james4beach said:


> Might that solve MarcoE's difficulty? If the corporation holds XIC, with lots of eligible dividends, can those flow through to the shareholders instead of being heavily taxed inside the corp?
> 
> I'd imagine this is a common scenario for doctors, dentists, etc.


I looked into it. Based on what I understand (and what my accountant understands), there are heavy limits to this. Even by passing dividends to a shareholder, you can only reduce the tax burden by roughly 10% (from 50% to 40%), as I'll explain.

For example, suppose a corporate account earns $10,000 in dividends (say from XIC or XBB). The normal corporate tax rate on "passive income" is roughly 50%. Hence $5,000 are owed in taxes. This is a very high tax rate, compromising a portfolio's ability to compound.

There is a mechanism called RDTOH, allowing a corporation to recoup up to ~33% of the "passive income" tax paid (it's actually less, and I'll explain why). To gain this advantage, a corporation must pass dividends to a shareholder. For every $3 of dividends to a shareholder, $1 of the corporate tax burden is reduced. Up to 33%. (I believe it used to be 30%, and the rate sometimes changes, but for this example, I'll use 33%).

In this scenario, with a tax bill of $5,000, it should be possible to recoup up to $1,667 (33% of the $5,000 tax owed), but only if $1,667 x 3 = $5,000 is paid to the shareholder.

So if $5,000 (of the $10,000 earned) is paid to a shareholder, the corporate tax burden is now $3,333 ($5,000 - $1667) = roughly 33% of the original $10,000 earned. But wait.

The $5,000 paid to a sharesholder is taxed as personal income. There is a dividend tax credit that can help. In a typical, average tax bracket here in Ontario, a shareholder can expect to pay between 9% - 12% (or more) on dividends, after the tax credit. Suppose 12% tax. So the $5,000 paid to the shareholder will be taxed (personally by the shareholder) at about $600.

The total tax burden is now $3,333 (paid inside the corporation) + $600 (paid by the shareholder) = $3,933. Let's round it up to $4,000.

That's about 40% combined tax on dividends earned.

So passing dividends to shareholders only reduced the tax from 50% to 40%. That's still a punishing tax rate that cripples a portfolio's ability to compound.

This is my understanding, at least. What mechanism is available that allows eligible dividends to "flow through to the shareholder of a small business at zero tax?" I've never heard of such a mechanism. Naturally I'm curious.

Note: The RDTOH limit changes over time, so I used 33% as an example here. Also note: I'm NOT an accountant, or particularly good with numbers, just a guy with Google. So I might be getting some details a bit wrong.


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## james4beach (Nov 15, 2012)

Wow. So (assuming those details are right) it doesn't offer much of a savings.

MarcoE, from what I've read of HXT and my understanding of their swaps and counterparty exposures, my "guesstimate" for the potential risk posed by their derivative approach is a possibility of a one-time 5% to 30% loss if everything were to go sour. I'm not an expert in this at all, so please understand that's just my rough feeling of the kind of risk this poses. I am somewhat comforted by the fact that there is $1.7 billion invested in HXT which is quite a strong vote of confidence in it.

I suggest downloading their audited financial statements. Read and understand the structure.
https://www.horizonsetfs.com/horizons/media/pdfs/annualreports/2017/HXT-EN-AR2017.pdf

I am not trained in this field, but here is how I interpret that 2017 annual report (I suggest waiting until you see the 2018 report come out): on page 21 you'll see their actual investments. About 4% of the fund is in swaps, and the rest is in cash. On first examination this makes it look like the risk is limited to 4%, but it's actually more than that. Their swap level varies throughout the year and I believe it goes as high as 10%.

On top of that there's another risk that isn't talked about much, which is the risk of what they call "cash". These are deposits at banks, but uninsured deposits. (It's over $1 billion). So if one of the swap banks collapses and they also have cash deposited with them, how safe is the cash? Probably not very.

_There is no question that HXT's assets are riskier than XIU holdings of individual stocks._ You're looking at risk in the swap values (could blow up) plus some risk of the cash (could have partial loss in bank insolvency). Uninsured cash values sitting around are not as safe as securities holdings, in my mind.

Another much more subtle risk, which I learned about during the 2008 crisis, is the _opportunity cost_ if their derivatives become impaired during a crisis. The gains of HXT come from the swaps; otherwise the cash just sits around. If one of the swap counterparties blows up, and the swaps blow up, and then stocks rally... you don't get that rally. Your fund is "stuck" at the old value, missing the fun.

Again putting on my amateur hat, if I were forced to measure these risks I might say:
swap blowup risk ... 10%
cash blowup risk ... 10%
opportunity cost risk ... 10%

Which is how I got that 30% figure. Obviously, this is totally non-professional, and I have no idea.

One potential mitigation to this, that's probably a reasonably good idea, is to switch back from HXT to XIU if you ever see any signs of a brewing banking crisis. Indicators would be things like plummeting bank stocks in any of the big 6 banks. That takes some work, but is worth doing if someone owns HXT. One should also monitor the number of outstanding shares. If you see big reductions happening (redemptions) then, as others are doing, you should also flee HXT.

At the end of the day you have to weigh the potential risk of HXT going wrong against the tax benefit it offers.


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## andrewf (Mar 1, 2010)

https://www.bdo.ca/en-ca/insights/tax/tax-articles/refundable-tax-rules-business-owner-planning/



> *Dividends received from other corporations*
> The explanation above deals with the RDTOH account that arises from tax on investment income earned in the corporation, also known as Part I refundable tax. However, there is a second component of the RDTOH account, and that comes from dividends received from other corporations. *When a corporation holds portfolio investments in other Canadian corporations, dividends from these corporations are not subject to regular corporate tax, but are subject to a fully refundable tax of 38.33 percent, known as Part IV tax.* For dividends from non-portfolio, or “connected” corporations (where there is at least 10 percent ownership), these dividends can be received tax-free, except where the recipient corporation must pay tax equal to the amount of tax refunded to the payor upon payment of a dividend. In that case, the tax is added to the recipient’s RDTOH account.


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## MarcoE (May 3, 2018)

andrewf said:


> When a corporation holds portfolio investments in other Canadian corporations, dividends from these corporations are not subject to regular corporate tax, but are subject to a fully refundable tax of 38.33 percent, known as Part IV tax.


Interesting. If I understand this correctly, it means:

* If my corporation (call it Widgets Inc as an example) receives $100,000 dividends from other Canadian corporations, the tax bill will be 38.33% -- $38,333.

* If Widgets Inc passes the above dividends ($100,000 in this case) to a shareholder, the $38,333 is refundable.

* The shareholder then pays tax on the $100,000 at his/her individual tax rate, which is lower than the corporate tax rate.

So the two conditions are: 1) Receive dividends from other Canadian corporations, and 2) Pass those dividends to shareholders.

If this is correct, Widgets Inc can invest the majority of its portfolio in other Canadian corporations, then pass the dividends received to shareholders. The shareholders will then pay the tax at the individual rate, which should be much lower.

How does this affect Widgets Inc investing in a Canadian index fund, such as XIC or XIU? Any idea if ETFs that track the TSX are eligible?

Some of this might be beyond this group, but this is good info to collect and bring to my accountant. I called the CRA and spoke to a senior agent, and they didn't even understand the difference between active income and passive income, let alone know about these more complex rules.

The problem is that a corporate portfolio, to enjoy this benefit, will have to greatly skew toward investing in Canadian stocks, at the expense of other types of investments (international/US stocks, bonds, real estate, etc). This will reduce taxes but also reduce diversification.


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## Spudd (Oct 11, 2011)

MarcoE said:


> How does this affect Widgets Inc investing in a Canadian index fund, such as XIC or XIU? Any idea if ETFs that track the TSX are eligible?


The ETF companies provide this breakdown for historical tax years. For example, if you go to https://www.blackrock.com/ca/individual/en/products/239837/ishares-sptsx-capped-composite-index-etf , click on "full chart" under the distributions section in the left column, then click on "calendar year" in the pop-up that comes up, you'll see that for 2017, XIC distributed about 93 cents per share, of which 62 cents were eligible dividends. 2016 was better, it was almost all eligible dividends.

Anyway, you can do this with all the fund companies and funds, you just have to dig around in their websites to find the data.


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## MarcoE (May 3, 2018)

It sounds like the best solution for a taxable, corporate account is to invest largely in Canadian stocks. Or directly or in Canadian stock ETFs such as XIC.

The dividends they pay will be eligible dividends, and can flow freely from the corporation to the shareholder (then the shareholder pays personal tax).

Meanwhile, other types of dividend-paying investments -- bonds, REITs, international and American stocks -- will be taxed 50% within the corporation, then taxed again when passed to a shareholder.

The downside is the lack of diversification. To avoid the punishing dividend tax, I would need to have my investments in Canadian corporations only, without an ability to successfully invest in other asset classes.


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## Eclectic12 (Oct 20, 2010)

The other factor for the XIC 2017 distribution that may or may not be of concern is that most of the missing taxable distribution is $0.29118, which seems to be a re-invested distribution (aka phantom distribution). 

Search for XIC in this list for 2017 of BlackRock Canada ETFs:
https://globenewswire.com/news-rele...Gains-Distributions-for-the-iShares-ETFs.html


Info on re-invested distributions.
https://www.adjustedcostbase.ca/blog/phantom-distributions-and-their-effect-on-adjusted-cost-base/
https://business.financialpost.com/news/fp-street/why-phantom-distributions-can-be-scary-at-tax-time



The 2016 XIC breakdown does have more of the taxable distribution as eligible dividends at $0.60707 but is also has return of capital (RoC) of $0.02612 that has to be subtracted from the cost base. In addition there are small amounts of "Non Eligible dividends", "Other Income", "Foreign Income" and "Foreign Tax Paid". The 2016 final re-invested distributions says $0.00 for XIC for that year.


All the factors are listed in this TaxTips article .... https://www.taxtips.ca/personaltax/investing/taxtreatment/etfs.htm


For a regular investor, the key is to be aware. The work is relatively easy when it has been planed for. There's also sites like https://www.acbtracking.ca/how_to_use or https://www.adjustedcostbase.ca/ or a spread sheet or an accountant to deal with it. 

The corporate treatment might or might not be of concern.


Cheers


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## Eclectic12 (Oct 20, 2010)

MarcoE said:


> ... Or directly or in Canadian stock ETFs such as XIC. The dividends they pay will be eligible dividends, and can flow freely from the corporation to the shareholder (then the shareholder pays personal tax) ...


ETFs are more of a YMMV year by year ... which may not be what you want.

When I expand the XIC breakdown to show 2001 through 2017 ... *none of the past sixteen years or so are 100% eligible dividends*. 2006 through 2013 plus 2016 have most of the taxable distribution as eligible dividends while other years this drops to as low as about 30%.




MarcoE said:


> ... Meanwhile, other types of dividend-paying investments -- bonds, REITs, international and American stocks -- will be taxed 50% within the corporation, then taxed again when passed to a shareholder ...


REITs and ETFs typically pay a mix of income types so what makes a REIT different than XIC to be the only one taxed at 50%?

Both on any given year can pays "Other Income", "Foreign Income", "Other Income", "Capital Gains", "Return of Capital" etc. The thing I am aware of that the REIT does not pay is re-invested distributions.

Unless I am missing something - it reads to me that in both cases, whatever fits the "dividends" definition to qualify for the refundable tax of 38.33 percent, known as Part IV tax will be fine and whatever is paid as anything else is going to be a problem.


Maybe the history has enough large eligible dividends years that you don't care about the years of 31%, 34%, 54% or 64% eligible dividends.


Cheers


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## MarcoE (May 3, 2018)

That's a good point, I was coming from the false assumption that 100% of XIC dividends are eligible, and that 0% of dividends from REITs are eligible. (I believe that 0% of dividends from bond funds like XBB are considered eligible.)

When I look at statements from TD Web Broker, I just see how much dividends I earned from each ETF. I don't see a breakdown between eligible and ineligible.


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## Eclectic12 (Oct 20, 2010)

Mixed income paying investments ... whether they be ETFs or REITs tend to vary. Checking the history gives an idea but is not guarantee of what will be paid.

After noticing so much of RioCan's distributions were "Other Income" (i.e. not the tax advantaged return of capital [RoC] or capital gains), I moved my holdings into my TFSA from my taxable account. NorthWest Medical Properties on the other hand has typically been 94% to 100% tax deferred so despite the bookkeeping, I prefer it in a taxable account (CG treatment in the future or worst case, as paid).


The ETF provider will have the breakdown for the ETFs with the added wrinkle of the re-invested distributions. REITs typically have an investor's section that will outline the breakdown. If not, there is the CDS Innovations web site (https://services.cds.ca/application...s/-EN-LimitedPartnershipsandIncomeTrusts?Open).


Since you are looking for eligible dividends, XIU may be a bit better. From 2006 to 2017 as it seems to have a more consistent record of the payouts being a high percentage of eligible dividends (looks like 39% as a low and a bit under 100% as the high). I leave the detailed analysis to you.

If you prefer something like the six pack, then 100% would be eligible dividends, without the phantom distributions.
https://www.canadianmoneyforum.com/showthread.php/132442-The-6-Pack-Portfolio


Cheers


Cheers


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## larry81 (Nov 22, 2010)

Warning for anyone with a CCPC using a holdco/opco setup and getting more than 50k in distributions in the holdco:



> Earlier this year, the government passed new tax legislation governing Canadian-controlled private corporations (CCPCs), including incorporated professionals. As we enter the final weeks of 2018, one new measure is of particular concern — the potential looming loss of the small business deduction (SBD) in 2019 for corporations with more than $50,000 of passive investment income in 2018.


https://www.looniedoctor.ca/2018/03/02/ccpc-new-passive-income-rules-professional-corporation/
https://www.financialhorizons.com/b...rm-passive-income-within-private-corporations

I was hit directly with this measure and i am currently pondering the idea of converting my VCN to HXT... this would allow me to significantly lower the distributions in my holdco.

Except for HBB, i am not confortable swapping VUN for HXS because the loss of diversification (SP500 vs total market). Same thing with HXDM vs VIU.


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## james4beach (Nov 15, 2012)

larry81 said:


> i am not confortable swapping VUN for HXS because the loss of diversification (SP500 vs total market)


There isn't much diversification gained by going with the total market versus S&P 500. The two are extremely similar and it's kind of splitting hairs.


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## AltaRed (Jun 8, 2009)

I agree. I only made the swap to VTI (total market) from SPY (S&P 500) back in the bowels of Dec 2008 to capture a tax loss for future use.


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## james4beach (Nov 15, 2012)

Could someone in this predicament ... with a big investment portfolio inside a corporation, with punitive taxes on dividends ... benefit from an approach like what I'm using in my Lowdiv strategy, where I choose securities to construct a (diversified) portfolio with a very low dividend yield? I came up with this for similar tax reasons, trying to emphasize capital gains and minimize dividends.


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## james4beach (Nov 15, 2012)

larry81 said:


> Warning for anyone with a CCPC using a holdco/opco setup and getting more than 50k in distributions in the holdco:
> 
> https://www.looniedoctor.ca/2018/03/02/ccpc-new-passive-income-rules-professional-corporation/
> https://www.financialhorizons.com/b...rm-passive-income-within-private-corporations
> ...


So the issue isn't purely about having an investment portfolio inside the corporation, but only becomes a problem when distributions (dividends+interest) exceed 50K. Am I understanding that correctly?

Given typical dividend/interest distributions of around 2.5% yield for a diversified couch potato investment portfolio (even less yield in the All Weather or Permanent Portfolio), that implies to me that this only becomes a problem if the investment portfolio inside the corp exceeds about $2 million. With a portfolio smaller than 2M, wouldn't the distributions generally keep you within that 50K limit?

If I'm understanding that right, then it sounds like the new tax rules are intended to discourage the hoarding of more than ~ 2M in passive investments inside a holding corp.


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## james4beach (Nov 15, 2012)

A quick calculation says that the All Weather portfolio, which is an alternative to the typical balanced couch potato, yields even less, around 2.2% using the XIU/ZSP/XBB/MNT model I listed in the other thread.

It seems to me you could then keep as much as $2.3 million passively in a corporation and still stay under the 50K limit for distributions.


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## larry81 (Nov 22, 2010)

james4beach said:


> There isn't much diversification gained by going with the total market versus S&P 500. The two are extremely similar and it's kind of splitting hairs.


i understand that the SP500 is about 80% of the US Total Market but historical returns demonstrate there still some smallcap premium to capture by holding a fund like VTI/VUN.

https://www.wallstreetphysician.com/invest-sp-500-total-stock-market-index-fund/

Returns	S&P 500 VTI
1-year	-7.05%	-5.85%
3-year	7.95%	9.95%
5-year	6.69%	8.33%
10-year	10.51%	13.06%
15-year	5.66%	8.14%

my previous post mentionned HXDM wich is horizon emerging market fund, their euro fund is even more concentrated, HXX is tracking the Euro Stoxx 50 !

Horizon should come up with "swap based one fund" like ishares and vanguard did.


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## larry81 (Nov 22, 2010)

james4beach said:


> So the issue isn't purely about having an investment portfolio inside the corporation, but only becomes a problem when distributions (dividends+interest) exceed 50K. Am I understanding that correctly?
> 
> Given typical dividend/interest distributions of around 2.5% yield for a diversified couch potato investment portfolio (even less yield in the All Weather or Permanent Portfolio), that implies to me that this only becomes a problem if the investment portfolio inside the corp exceeds about $2 million. With a portfolio smaller than 2M, wouldn't the distributions generally keep you within that 50K limit?
> 
> If I'm understanding that right, then it sounds like the new tax rules are intended to discourage the hoarding of more than ~ 2M in passive investments inside a holding corp.


you understand it well james, the problem is manifesting itself when the portfolio reach a certain a mount and distribution exceed 50k.

However, the caveat is that the taxable capital gain also count torward the "passive income", they call it the "Adjusted Aggregate Investment Income".

BDO have a nice writeup:
https://www.bdo.ca/en-ca/insights/t...tment-income-impact-small-business-deduction/

The solution is really to avoid pilling investment in a holdco, flow more money to the shareholders and/or purchase alternative investment like insurance policies


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## james4beach (Nov 15, 2012)

larry81 said:


> However, the caveat is that the taxable capital gain also count torward the "passive income", they call it the "Adjusted Aggregate Investment Income".


Ouch, I didn't realize that part.


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## james4beach (Nov 15, 2012)

I stumbled into an interesting case where the derivative structure of the Horizons ETF will hurt their performance, resulting in lower performance than a conventional ETF.

It's not a very big deal, since the spinout in question (from CSU) was probably a small % of the Horizon funds, but still interesting:









CSU Constellation Software


The Topicus thing really confused me too. Luckily I hold this in a TFSA but I'm still curious how to think of it from a % return standpoint. They seem to be in limbo in my trading account. How many Topicus shares were given for each share of CSU ?




www.canadianmoneyforum.com


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