General Business Assurance 8 September 2009 237
Disclaimer Financial Adviser s Guide PPS Insurance, in making this guide available, is not supplying advice, making any recommendation or providing any guidance, but is merely objective information about the matters concerned. The information appearing in this guide may be amended without notice and PPS Insurance does not guarantee the accuracy of any statement contained in this guide. In no event shall PPS Insurance, nor any of its affiliates or employees and officials, be held liable for any damages or losses of whatsoever nature flowing directly or indirectly from reading or otherwise utilising this guide. 8 September 2009 238
INTRODUCTION Owners and employees of a company or practice work hard to establish a successful, thriving and profitable business. Most businesses have key individuals and/or partners that are relied on and who contribute substantially to the success of that business. The running of such a business requires that various risks faced by the business are managed to ensure long term success. One such risk is the loss of valuable personnel or major shareholders due to illness, disability or death. Therefore the business will have an insurable interest in the lives of key individuals and PPS acknowledges this valuable internal relationship. Business Insurance seeks to protect the business against the loss incurred in financial terms. Most small, professional and private practises need to address specific areas of risk protection. Business Insurance is life, disability or dread disease insurance, purchased on behalf of the business/practise on the life of a key individual whose services contribute substantially to the success of the business or to secure and finance a Buy-and-Sell Agreement between co-owners of a business/practise. In the unforeseen event of death, disability or impairment of a valuable individual (partner, key person), the operations of the business should continue as smoothly as possible and the impact on sales, productivity, expenses, loyalty etc minimised. The remaining owners/partners should be empowered financially to deal with all business contingencies following such an event without having to disrupt the business. PPS Business Provider products are designed to be flexible and comprehensive enough to provide the insurance cover necessary to fund any of the following Business Insurance agreements: Key-Person Insurance. Buy-and-Sell Agreements. Contingent Liability Insurance. 8 September 2009 239
KEY PERSON INSURANCE Introduction Key Person Insurance is life insurance effected by an employer on the life of an employee (the key person) whose services and knowledge are instrumental to the running of the business. The life policy is owned and paid for by the employer and when the key person dies, is impaired due to illness or is disabled, the policy proceeds are payable to the employer. In the same way that short-term insurance can compensate an employer for loss suffered as a result of fire, theft or water damage (the damaged or stolen asset can be replaced), Key Person Insurance can compensate the employer for the loss of a key person in the event death, disability or illness. The policy proceeds can be used in various ways by the business for example by: covering losses during the readjustment period; paying the additional expenses of finding, employing and training a new employee; and ensuring continuity of credit and helping to maintain the profitability of the business. For Example: Big Business (Pty) Ltd relies on their chief engineer, Jim, whose knowledge and expertise contribute to the profits of the business. Big Business effects a life and disability policy on the life of Jim. Big Business is the owner, payer and beneficiary of the policy. In the event of Jim s death or disability, the proceeds will be payable to the company. These proceeds will then be used to find a replacement for him and to cover any losses incurred by the business due to his untimely death or disability. 8 September 2009 240
Valuation of a Key Person It is often difficult to determine the value of a key employee. In practice, the amount of cover that a business should have on a key employee will be based on one of the following measurements: seven times the annual salary of the key person or, the number of years it will take for a replacement to reach the key employee s present level of profitability multiplied by the loss in profits due to replacement of the key individual or, itemising the cost of replacing the key person e.g. How much will it cost to replace the key person, How much is the key person worth to the company in net profits? Benefits of Key Person Insurance The employer has peace of mind. Covers a loss during a period of re-adjustment. Pays additional expenses of finding, employing and training new employees. It ensures continuity of credit and effectively of the business and its activities. 8 September 2009 241
Tax Implications of Key Person Insurance Income Tax Estate Duty Capital Gain Tax (CGT) If the requirements of section (11)w of the Income Tax Act are complied with, the premiums paid under a key person policy by the employer, will be tax deductible. Proceeds at death or disablement If the premiums were deductible in terms of s. 11(w), the proceeds will be included in the employer s gross income in terms of par. (m). If the premiums were not deductible in terms of s. 11(w), the proceeds are tax free At death, disablement or dismissal the employee receives nothing. There are therefore no tax implications for the employee. The proceeds are normally exempt from estate duty if the following requirements were met: (i) the policy was not taken out on behalf of or on the instructions of the deceased; and (ii) no premiums on the policy were paid or carried by the deceased; and (iii) no amount in terms of the policy is paid to or utilised for the benefit of - the deceased's estate; - a relative/dependant of the deceased; or - a family company pertaining to the deceased. See Annexure 1 Definition of a Family Company Employers will receive all policy proceeds free from CGT in their hands as a consequence of being the original beneficial owners of such policies. This will apply to proceeds received as a consequence of surrender or cession of the policy. In the event that the policy is ceded to employees or directors of that company, employees or directors whose lives were insured in terms of a conforming policy in terms of section 11(w) will receive policy proceeds free from CGT in their hands, provided the premiums were actually deducted by the company. Note: PPS can not cede to employee so this is irrelevant. 8 September 2009 242
BUY-AND-SELL AGREEMENTS Introduction In the event of the death or disability of a partner/member or shareholder (See Annexure 2 Business Entities), it is vital that provision be made for the sale of the deceased s interest in the business and that sufficient funds are available to the survivors to purchase the deceased s interest so as to ensure the continuation of the business. Failure to do may result in: Uncertainty as to who would replace the deceased partner/member shareholder in the business. A danger that the business may have to be liquidated. Uncertainty as to whether sufficient finances would be available to purchase the deceased s interest from his estate. Uncertainty as to the purchase price of the deceased s interest in the business. The solution is a Buy-and-Sell Agreement, whereby provision is made for the sale of the deceased s interest in the business and the purchase price is secured by way of a life insurance policy on the life of the deceased. Funding this agreements by way of the PPS Business Provider policy means that the proceeds from the life cover, disability cover and dread disease cover, all conveniently available under a single policy, can be used to buy the life insured s interest in the business in the event of death disability or incapacity. What is a Buy-and-Sell Agreement? A business Buy-and-Sell Agreement contains the following essential terms and conditions: A definite agreement made by the partners obliging each partner (and his executor) to sell, at death, disability or retirement, his interest in the business to the surviving/remaining partners, and committing the partners to purchase the deceased, disabled or retired partner s interest. A method of valuing the deceased, disabled or retired partner s interest or an agreement on the price to be paid based upon a relevant valuation, subject to periodic review. Structure of the Plan Business owners enter into a contract, the Buy and Sell Agreement that determines the buying price of a partner s/member s or shareholder s interest as well as the buyer(s) of the interest. Each owner effects a life policy on the life of the co-owner(s). The premium payer(s) must be the owner(s) of the policy and no premium must be paid by the life insured. 8 September 2009 243
Premium Liability of Each Owner Example: Three partners enter into a Buy-and-Sell Agreement to ensure that in the event of a partner s death, the other partners can buy his share in the business. Three partners A, B and C have the following interest in the business: A - 60% B - 25% C - 15% Taking a closer look at the insurance cover A and B will buy in order to ensure that they can buy C s share of the business: A as well as B will buy life cover policies. C will be the life insured under both of the policies. The sum insured of each of the policies will be determined in relation to the value of C s share of the business. Suppose that the value of C s share is R 1 000 000; then the sum insured under A s policy will be: 60 85 multiplied by R 1 000 000; and 25 the sum insured under B s policy will be: multiplied by R 1 000 000. 85 In the event of C s death the proceeds from both policies, with a combined value of R 1 000 000, will be used by A and B to buy C s share of the business from his estate. Similar insurance cover will be put in place to ensure that in the event of A or B s death the remaining partners can buy the deceased s share in the business. 8 September 2009 244
Benefits of Buy-and Sell-Agreements A guaranteed buyer and guaranteed price for the interest of each party is provided in the event of the party s death - this provides a reasonable value for the deceased s interest, eliminating uncertainty for the heirs. It creates ready cash that can be used at the death of the deceased for the purchase of the deceased s interest in the business. The surviving parties are ensured outright ownership of the enterprise. It guarantees stability and continuity of the enterprise, and ensures the goodwill of employees and creditors. A whole or a portion of the purchase price can be provided for the deceased s interest. Full ownership by the surviving partners are guaranteed at a predetermined price. Dispute amongst the heirs is eliminated. It guarantees a reasonable price in cash for the heirs, which is paid without delay. It relieves the deceased s personal estate of all liabilities and obligations towards the creditors of the enterprise. It prevents the business from being drained of its capital resources. 8 September 2009 245
Tax Implications Income Tax Estate Duty Capital Gain Tax (CGT) No tax relief for the partners/ members/shareholders who effect a policy on each other s lives. Policies on life of deceased owned by 3 rd party are deemed property in the estate, unless it complies with section 3(3)(a)(iA) of the Estate Duty Act: The original beneficial owners of buy-and-sell policies will receive policy proceeds free from CGT in their hands. A CC may give financial In the event that a correctly (i) The policy effected or assistance in purchasing interest structured policy is ceded back to acquired by a person who on in itself. If all the requirements of the life insured (on dissolution of the date of the death of the section (11)w are met, these a partnership for example), the deceased was a partner of premiums may be tax life insured (new owner) will the deceased or held a share deductible. Proceeds will then receive policy proceeds free from or like or interest in the be included in the CC s gross CGT in his/her hands provided business in which the income and will be taxed. that no premium on the policy deceased held a share was paid or borne by the life interest, and 'ii) The policy was used for the insured prior to the cession to him/her. purpose of acquiring the deceased interest or for the purpose of acquiring the whole or part of the PPS can not cede their policies absolutely so this is not applicable deceased share or interest in the CC or corporation, and ii) No part of the premium on the policy was not paid or borne by the deceased. However if a CC is the owner of the policy the policy may be deemed part of deceased s estate. 8 September 2009 246
CONTINGENT LIABILITY INSURANCE Introduction A business will always incur liabilities and often require facilities from the banking institution with which they transact. It is standard practice for creditors to request a surety or personal guarantor for the business s financial obligations to them. A suretyship is an undertaking by a surety (normally the business owners) to fulfil the financial obligations of the debtor to the creditor. The surety is dependant on the performance of the debtor, hence the term Contingent Liability. The surety binds himself/herself as well as his/her deceased estate as surety for the company s debts. On the death or permanent disability of the surety, the following may occur: The surety or his estate may be forced to settle the business s liabilities to its creditors, resulting in a reduction or insolvency of the surety s estate. This in turn may result in insufficient provision for the surety s dependants. The business debt may be called up, forcing the business to meet its financial obligation prematurely. PPS Business Provider provides insurance cover that can be used to fund a Contingent Liability Insurance agreement. Therefore by combining insurance cover with a Contingent Liability Insurance agreement the surety, for example the business owner (the insured), who has stood surety for the debts of the business is protected should he/ she die or become disabled. Contingent Liability Insurance prevents the personal estate of the insured surety from being affected by the debts of his/her business. Structure of the Plan The company effects a policy on the life of the surety. The effect of the surety s disability or illness may be the same as his death in respect of the contingent liability, since both the surety and his heirs would be prejudiced under these circumstances. The company must pay all contributions on the policy. On the death or disability of the surety, the proceeds of the policy must be used by the company to settle any of the company s obligations for which the life insured had signed as surety. The above-mentioned terms of the plan should be recorded in a written agreement between the company and the surety. This agreement should also provide that any surplus funds be applied to the repayment of the 8 September 2009 247
surety s credit loan account with the company (if one exists) and thereafter, in the best interests of the company. Example: Big Profits (Pty) Ltd want to expand and need to purchase some new equipment for the business. They apply for a loan from the bank and the loan is accepted on condition that Big Profits provide surety for the amount that will be borrowed. Stan, one of the directors stands surety for the loan on condition that he or his personal estate will not be prejudiced in any way in the event of his death or disability. Big Profits effects a life and disability policy on Stan s life. The company is the owner, payer and beneficiary of the policy. In the event of his death or disability, the proceeds are payable to Big Profits who use the money to pay back the loan which Stan stood surety for thereby releasing Stan or his estate from the obligations of the surety. Benefits of Contingent Liability Insurance Company The company is able to secure credit facilities in order to finance its expansion. The company will be able to meet its obligations in the event of the death or disability of the surety and will avoid potential insolvency. Surety The surety does not have the responsibility of paying the contributions. He knows that the company will have sufficient funds to meet the obligations for which he has stood surety. The surety s estate will not have to bear the liability for these obligations and his dependants/heirs will not suffer any financial hardship as a result of his having signed surety during his lifetime. 8 September 2009 248
Tax Implications Income Tax Estate Duty Capital Gain Tax (CGT) If the requirements of section (11)w are complied with, the premiums paid under a Proceeds are exempt from estate duty under section 3(3)(a)(ii) of the Estate Duty Act if: No CGT is payable if the policy was not effected at the insistence of the surety and no premiums Contingent Liability policy owned not effected by or at the paid by the surety, according to by the employer, will be tax deductible. instance of the surety; and paragraph 55(1)(b) of the Eighth Schedule of the Income Tax Act. Proceeds at death or disablement If the premiums were deductible in terms of s. 11(w), the proceeds will be included in the employer s gross income in terms of par. (m). no premium paid by surety; proceeds not used for benefit of relative/dependant; and may not be a family business. Not applicable to PPS since we do not allow absolute cessions If the premiums were not deductible in terms of s. 11(w), the proceeds are tax free 8 September 2009 249
Structuring Business Insurance There are two methods of structuring the insurance cover used to fund Business Insurance agreements. The policy can be either: A conforming policy A conforming policy is a policy that conforms to the requirements of section 11(w) of the Income Tax Act read together with the Minister of Finance s Regulations. If the policy conforms, the premiums up to 10% of the employee s (life insured s) remuneration, will be tax deductible in the hands of the employer/company and the proceeds on death or disability of the employee will be taxable in the hands of the employer/company. With a term policy, the full premium is deductible (i.e. not limited to 10% of employee s remuneration). A non-conforming policy A non-conforming policy is structured in such a manner that it does not conform to the requirements of section 11(w) and the Minister of Finance s Regulations. The premiums will not be deductible in the hands of the employer/company but the proceeds will be tax-free in the hands of the employer/company in the event of surrender, death or disablement. The choice of either of the above options will depend on whether the company has sufficient liquidity to forego tax deductions in respect of premiums and would rather elect to have tax-free proceeds, or whether the company would rather have taxable proceeds in order to have present premium deductions. (SEE ANNEXURE 1 Company owned policies and (Section 11 (w) Income Tax Act) 8 September 2009 250
ANNEXURE 1 Company-owned policies (conforming and non-conforming policies) Section 11(w) of the Income Tax Act contains stipulations regarding the deductibility of insurance premiums, which are paid by an employer on a policy on the life of an employee or director. These policies are often referred to as "Company-owned policies". An employer-employee relationship must exist or the insured must be a director of the company concerned. A director of a company is technically not necessarily an employee of the company; section 11(w) specifically makes provision for the inclusion of a director of a company. The term employer implies the existence of an employer/employee relationship. The following combinations are common: Employer Private company Close corporation Partnership One-man business Employee Any employee including a director. Any employee including member. Any employee excluding partners. Any employee excluding the owner. In the case of a sole proprietorship or partnership no employer-employee relationship exists between the owners and the business concerned. Deductibility of Premiums In terms of sect. 11(w) of the Income Tax Act a taxpayer may deduct the premiums paid in terms of a policy on the life of an employee/director from his taxable income if the following requirements are complied with: Section 11 (w) permits deductions in respect of: For Term policies the full amount paid for the premium is deductible. Policies that conform to the regulations promulgated by the Minister of Finance (conforming policy in terms of Regulation 2408). This sets out the following requirements in terms of conforming policies: There may only be one life insured in terms of the policy. The life insured may not be replaced by another life insured. Premiums may not increase by more than 15% per year and the terms must be contained in the policy contract. Premiums must be paid at least annually for: 20 years or, the term of the policy or, the life expectancy of the life insured, which ever term is the shortest. 8 September 2009 251
The minimum life cover must be: 80% x lowest annual premium (excluding costs for disability, accident cover and loading) x the smallest of the term of the policy, or the life expectancy of the life insured, or 20 years. Before a deduction will be allowed, the following additional conditions must be met: The employer must own the policy. The policy must be on the life of an employee/director. The employer must be the beneficiary of the policy: The deductions must not exceed the amount of the premium paid. No loans or advances against the policy may be outstanding unless: The loan or advance is included in the tax payer s gross income, or The Loan or advance was obtained in order to obtain funds required by the tax payer for the purposes of his/her trade in consequence of the employee s/directors ill health, infirmity, incapacity, retirement or cessation of services. The deduction allowed shall not exceed the amount of the premium paid and will be limited to 10% of the employee s remuneration. The effect of loans A loan, which was obtained on the security of the policy from the assurer, will be taxable income for the employer, but the premiums will still be deductible. A loan, which was obtained on the security of the policy from anyone other than the assurer, is not taxable income for the employer. No premiums will be deductible as long as the loan is outstanding, unless the loan was made in order to obtain funds because of the employee s ill health or termination of service. Taxability of proceeds If premiums are deductible, the policy proceeds are taxable. The taxable proceeds of the policy are decreased by: Loans taxable in the past; Premiums paid which did not previously qualify for a deduction. Non-conforming policy The premium on any policy not in accordance with the requirements mentioned above will not be deductible, but the policy proceeds will not be included under paragraph (m) of "gross income. 8 September 2009 252
ANNEXURE 2 Summary of Business Entities Formation Continued existence Dissolution Sole Proprietorship Partnership Close Corporation Private Company This is formed when a Formed when the partners Founded when a founding Formed when the natural person starts a have agreed to do so and statement is registered with Memorandum of Association business without a separate the partnership contract has the Registrar of Close and Articles have been legal person coming into come into existence. There Corporations. registered with the Registrar being. are no formal requirements of Companies, and a There are no formal for the formation of a certificate of incorporation requirements for the partnership. has been issued. formation of a sole proprietorship. A sole proprietorship does not continue indefinitely. It comes to an end when the owner stops conducting the business. A sole proprietorship comes to an end when the owner stops conducting the business, for what ever reason. A partnership does not continue indefinitely. It continues to exist only until the partners change. Then a new partnership is formed. A partnership can be dissolved by: Agreement between the partners Change in the members of the partnership Execution of the law The sequestration of a partner's estate. The insolvency of the partnership. Then the estates of all the partners will be sequestrated, unless the solvent partners undertake to settle all the debts of the partnership. A CC continues even if the members change, and will continue to exist until it is officially dissolved. A CC may only be dissolved in ways as prescribed by the CC Act, viz. by deregistration or liquidation as a result of dissolution. The dissolution of a CC does not mean that the estates of the individual members are sequestrated. A company continues even if the shareholders change, and will continue to exist until it is officially dissolved. A company may only be dissolved in ways as prescribed by the Companies Act, viz. by deregistration or liquidation as a result of dissolution. The dissolution of a company does not mean that the estates of the individual shareholders are sequestrated. 8 September 2009 253
Legal person Management Representation Sole Proprietorship Partnership Close Corporation Private Company A sole proprietorship is not a A partnership is not a A CC becomes a separate A company becomes a separate legal person. It is separate legal person and legal person as soon as it is separate legal person as merely the name given to a has no duties and powers registered with the Registrar soon as it is registered with business, which is severally from the partners. of Close Corporations. the Registrar of Companies conducted in the name of and a certificate of the owner. incorporation has been issued. The owner in the way he considers best manages the sole proprietorship. The sole proprietor represents his own business and there is no other party that can represent it. The partners in accordance with the partnership agreement run a partnership. The partners could agree that certain partners do not participate in management. The partnership trades through the partners and each partner has the authority to act as a representative and to bind the partnership, as long as they act within the boundaries of the partnership's business. In terms of the law, the management and ownership of a CC are not separate. Members may participate in the management, unless they have been disqualified in terms of the Act or a restrictive agreement between the members. All members with the required contractual capacity may act on behalf of the CC and represent the CC, unless prohibited by the Act or agreed upon by members in an association agreement. A company is owned by the shareholders and managed by the board of directors. The Companies Act requires this separation between management and ownership. The directors represent the company and act on behalf of the company. Shareholders, who are not directors, may not represent the company at all. 8 September 2009 254
Ownership of assets of the enterprise Owners of the Enterprise Capital Contributions Partnership Close Corporation Private Company Sole Proprietorship The business assets of the sole proprietorship belong to the owner. Per definition, a sole proprietorship is a business with only one member, viz. the owner, who must be a natural person. The capital for the sole proprietorship is provided by the owner - usually from his own funds or by borrowing money. The partners jointly own the assets contributed (in undivided shares). When the partnership is dissolved, assets are returned to the partners in accordance with the degree to which they contributed, unless otherwise agreed. A partnership must have at least 2 and no more than 20 partners (owners). The partners may be natural or legal persons. The partners must all contribute something to the partnership, be it in the form of money, property or services. The assets of a CC belong to the CC. Upon dissolution of the CC, the assets will be distributed amongst the members according to their members' interest, unless otherwise agreed. A CC must have at least one, but no more than 10 members. Members must be natural persons, or legal persons who represent natural persons in an official capacity. There is only one type of membership, but rights of members may vary depending on the association agreement. The members must all make an initial contribution, be it in the form of money, property or services. A CC' S capital is represented by the members' interest. The assets of a company belong to the company. Upon dissolution of the company, the assets will be distributed amongst the shareholders in accordance with their shareholding. A private company may have from 1 to 50 shareholders. Shareholders may be natural or legal persons. There are various types of shareholders (ordinary, preferential and deferred). Rights adherent to each type of share will vary, and will be determined by the 'articles' or the shareholders' agreements. The shareholders contribute the share capital of a company, and are represented by the shares held by the shareholders. 8 September 2009 255
Profit-sharing Disposition or transfer of owners interest Liability towards creditors Sole Proprietorship Partnership Close Corporation Private Company The profits belong to the owner and no declaration or distribution of profits is necessary. A sole proprietor does not have a share, interest or contractual right that can be disposed of or transferred. The sole proprietor and his business are one for legal purposes. The sole proprietor is personally liable for all debts of the sole proprietorship. At the end of a financial period, partners become entitled to the net profit of the partnership in terms of the stipulations of the partnership agreement. A partner may not transfer his partnership interest unless all the partners agree to this. If it does happen, a new partnership is formed. Ordinary partners are jointly and severally liable for the debts of the partnership, given that the debts were incurred in the name of the partnership and with the authorisation of the partnership. However, creditors may take steps against the partners, jointly and severally, only after the dissolution of the partnership. Members are entitled to a distribution of net profit as soon as a decision introducing such a distribution has been validated, or if the distribution has been validated by the approval of the annual financial statements. Members may not voluntarily dispose of or transfer their interests. It may be done only in accordance with the association agreement or with the permission of all the members. The debts of a CC are the CC's, not the members'. The liability of a member is limited to his original contribution to the CC. In certain circumstances a member may become jointly or severally liable for the debts of the CC. Shareholders become entitled to a portion of the net profit as soon as a final dividend has been declared. Shareholders may not voluntarily dispose of or transfer their shares. It may be done only in accordance with the 'articles of association', which contain restrictions in terms of which the shares first have to be offered to other shareholders. The debt of a company is the company's, not the shareholders'. The liability of a shareholder is limited to that which he contributed or undertook to contribute towards the company. In certain circumstances a shareholder may be held liable for the company's debt. 8 September 2009 256
Taxpayer Insolvency Sole Proprietorship Partnership Close Corporation Private Company All the profits of the business belong and accrue to the sole proprietorship. The profit of the business is taxed in the hands of the owner at his/her marginal rate of tax. Sole proprietors are provisional taxpayers. The insolvency of a sole proprietor's business will lead to the sequestration of his estate. Each partner is taxed on his/her share of the partnership income whether withdrawn or not. This share is then added to the partner s other income. If the firm makes a loss, each partner may deduct his/her share of the loss from his/her other income. Partners are provisional taxpayers. The insolvency of a partnership will result in the estates of all the partners being sequestrated, unless the solvent partners undertake to pay the debt of the partnership. A CC is a separate taxpaying entity. A CC pays income at a rate of 28% on its taxable income. In addition, a withholding tax on profits distributed is levied at a rate of 10%. It is required to pay provisional tax each half year during its financial year and a third topping up payment within six month after the end of the tax year, if necessary. Members of a CC are provisional taxpayers. The insolvency of a CC does not result in the members' estates being sequestrated. A company is a separate tax-paying entity. A company pays tax at a rate of 28% on its taxable income. In addition, a withholding tax on profits distributed is levied at a rate of 10%. Companies, as provisional taxpayers, are required to pay tax each half year during its financial year and a third topping up payment within six month after the end of the tax year, if necessary. The insolvency of a company does not result in the sequestration or liquidation of the shareholders' estates. 8 September 2009 257
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