A looming tax crackdown on the private equity industry will raise significantly less revenue than expected, tax experts have warned.

The disclosure is likely to fan the flames of the debate about whether further curbs on the industry should be introduced.

From next month, tax bills of private equity-backed companies are set to rise by tens of millions of pounds a year after rules restricting tax relief on interest payments are implemented fully.

But industry experts expect the extra revenues will be smaller than anticipated by Revenue & Customs when it announced the phased introduction of the new rules two years ago.

Paul Megson, a partner of KPMG, said: "I am not sure it will be terribly effective as a revenue raiser." Tim Hughes, partner of PwC, said: "The Revenue might be disappointed."

The regime brings private equity debt within the scope of "transfer pricing" legislation, which limits the tax relief given to heavily borrowed companies. These limits are based on the maximum debt that an independent third party lender would be willing to provide.

Changes in the debtmarkets and the banks' appetite for risk have reduced the impact of these rules because it has become easier for a company to show an independent lender was prepared to make large loans.

The complex ownership structure of private equity investments meant that until March 2005, very few private equity-backed companies were subject totransfer pricing rules. Anton Hume of BDO Stoy Hayward says that before March 2005 many such companies paid little tax since the level of interest deductions on bank debt and shareholder debt tended to swamp their tax-able profits. All deals agreed or refinanced since March 2005 are already subject to the new constraints.

Calls by unions and some Labour backbenchers for the scrapping of tax relief on interest costs incurred by private equity-backed businesses have so far been rebuffed by the Treasury.

Even though there is widespread opposition to wholesale reform of the rules allowing interest costs to be deducted against tax, some industrialists and tax specialists believe there is scope for further tightening of the tax treatment of interest for highly geared companies.

Although the Treasury is unlikely to consider further reforms soon, some experts think it will come under pressure to fall in line with other jurisdictions that have more prescriptive rules.

In France, Germany, the Netherlands, Spain, the US and Japan, the tax authority decides how much interest is deductible by reference to an explicit debt to equity ratio. The US also limits the deductibility of interest in certain circumstances where the interest income is not subject to US taxation.

Chris Sanger of Ernst & Young warned against a limit for interest deductibility. He said it would be unfair because everyone had the option to use debt and it could hit companies that were highly geared because of trading problems.

The Revenue is also reviewing the tax treatment of shares owned by managers of the private equity-backed company and private equity executives. It is discussing the issue with the British Venture Capital Association, which has been told any proposals will be the subject of public consultation. Last year, the Revenue dropped an attempt to tax executives' "disproportionate" capital gains as income after taking legal advice.

Routes for the revenue

How the Treasury could take more tax from the private equity industry

*Revenue & Customs is reviewing the tax treatment of management equity, the shares acquired by executives of the target company, and of 'carried interest', private equity managers' share of the profits in the funds

*Interest deductions are being scaled back by Revenue & Customs following the extension of 'transfer pricing' rules to the industry

*The idea of bringing in stricter limits on the amount of interest that can be deducted against tax has been floated. Most other jurisdictions have more prescriptive rules than in the UK

*Interest on shareholder loans could be reclassified as a form of dividends in cases where shares are 'stapled' to loan notes and cannot be traded independently. This idea has been rejected by the industry because it could have unintended consequences and would be easy to circumvent