The Treasury is threatening to crack down on the tax treatment of private equity deals and the super-gearing that traditionally spices up returns for investors.

Ed Balls, the Treasury Minister responsible for the City, will today announce a review of the tax treatment of debt where it replaces equity in highly leveraged private equity deals.

Mr Balls will say that he has no problem with companies owned by private equity deducting interest as a business expense in the way that most quoted businesses do.

“We have no plans to review this principle,” he is expected to tell a London Business School audience today.

“However, concerns have been raised with the Treasury that something further may in some cases be occurring — in particular that ‘shareholder debt’ is replacing the equity element in highly leveraged private equity funding arrangements.”

Such debt is in fact a form of equity, he is due to say, and he will question whether deal-makers should be allowed to treat it as debt for tax purposes.

In 2005 the Government introduced reforms to make it harder for equity to be disguised as debt. Mr Balls argues that the regime could be toughened up again to ensure that rules are working as intended.

Politicians are under pressure from trade unions to crack down on private equity firms, which have been accused of short-termism and asset-stripping. The cross-party Treasury Select Committee this week announced an inquiry into private equity.

Last week the industry attempted to defuse growing union hostility by setting up a working group under Sir David Walker to lay down how transparency could be improved.

So-called shareholder debt is high-risk deferred debt lent by private equity groups to the specially created companies that own the companies invested in. It reduces the need for true equity capital by up to 95 per cent and spectacularly boosts equity returns, as long as deals succeed.

It comes at the bottom of the pecking order in the event of a winding up, below senior bank debt and mezzanine finance, which would be unaffected by the review. To qualify for tax relief, private equity firms should be able to demonstrate that it was lent on commercial terms.

According to tax accountants, the practice of loading up with shareholder debt is at the heart of most private equity deals. A crackdown could seriously reduce the volume of deals in the future.

Shareholder debt is often sourced offshore, so the Exchequer loses out twice: in reduced corporation tax receipts from the private equity-owned company and because any profit on the loan is earned outside the UK.

A spokesman for the British Venture Capital Association said last night: “We look forward to contributing to the review.”

Institutions face votes pressure

Ed Balls, the City Minister, has revived the threat of making institutional investors say how they vote on listed company resolutions, The Times has learnt. He told institutions at a meeting yesterday that he expects them to do more in voluntary steps to boost transparency if they are to avoid a statutory clampdown. The Institutional Shareholders Committee will now try to strengthen a draft code, which will oblige institutions to publish voting details or say why they are not doing so. Many publish, but others are wary of the cost and risks to relationships with company managers.

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