As a result of restrictions on the deductibility of finance costs in investee companies from April 2007, funds will see a significant increase in tax costs which in many cases could not have been predicted when their investments were made.

Stephen Quest, head of tax transactions at Grant Thornton, comments: "The taxation of private equity funds has been in a state of flux for the last two years. The market needs stability to enable deals to be completed with a degree of certainty. Clarity in this area would have provided a boost to the private equity sector which has brought so much to the British
economy over the last year."

In light of the unchanged conditions, says Grant Thornton, the major issues facing the private equity market remain the deductibility of interest, withholding tax, and the tax treatment of management teams.

For portfolio companies, the most draconian measure to impact funds is the retrospective application of the transfer pricing regulations to the financing of investee companies. From April 2007, amounts payable to private equity
funds in respect of finance deemed not to be available on an arm's length basis may not qualify for a deduction for corporation tax relief. The effect on returns is significant and unfair; the new rules can increase the cost of finance by 3-5% for investee companies, despite the fact that at the time finance was put in place no such legislation existed.

Quest says: "We had hoped to see a Pre-Budget in which the Chancellor put this right. His failure to do so will result in private equity funds taking a hit in April. It also sets a dangerous precedent and undermines the basis upon which funds will make investment decisions in the future."

As regards withholding tax, Grant Thornton says that significant uncertainty exists as to whether withholding tax needs to
operate on interest paid on many international fund structures. This needs to be clarified as soon as possible.

For management teams, the treatment of ratchets remains worrying. AlthoughiIn August 2006, HMRC provided welcome confirmation that the British Venture Capital Association (BVCA) safe harbour would apply to 'ratchets'
where management teams acquire sweet equity, the Pre-Budget Report has failed to address the thorny issue of post-acquisition changes to ratchets which cause so much difficulty when private equity investments are re-financed.

Grant Thornton says that tax law remains unclear with regard to earn-outs. Quest remarks: "The tax law in this area is in a considerable mess with uncertainty as to whether future receipts are taxed on a current or deferred basis. There is urgent need for a reform in this area."

Stephen Quest concludes, "Private equity has become a mainstream and permanent factor in capital markets and deserves a fiscal regime that is consistently applied and delivers certainty to the funds in assessing investment opportunities in the UK. It remains the case that there is significant uncertainty and this is disrupting the flow of funds into the UK market. We hope that there will be substantive changes in the next Budget and that the introduction of retrospective attack on pre-2005 investments is dropped."