The changes, if approved, would fly in the face of government efforts to boost foreign investment in Japan and could encourage retaliation by other countries, the firms say.
In their first public response to the proposals, investors including Warburg Pincus, JP Morgan Partners and The Carlyle Group said the changes would hamper the activities of all private equity firms seeking to buy, revive and sell companies in Japan.
This will have an enormous impact on our business ... and a tremendous adverse effect on Japan, said a partner at one firm, who did not wish to be identified.
This will create not only significant impact on buyout investment, but also a lack of confidence among overseas investors in Japanese capital markets, the source said, speaking on behalf of the Private Equity Association, a group of nine buyout firms opposing the tax proposals.
The next few weeks will be crucial, he added.
In 2004 alone, Japan attracted $8 billion in private equity investment, according to the Asian Venture Capital Journal.
The foreign and Japan-based groups speaking out against the proposals have committed more than $4 billion.
This is a project of the tax bureau of the Ministry of Finance, whose objective is to maximise their tax revenue, said the partner.
The tax authorities can increase revenue on the capital gains tax, but if other nations retaliate and impose a similar system, then Japan suffers, he said. Just think about how much money Japanese companies have invested abroad.
The proposed changes, which would result in a withholding tax of 20%, have already been approved by Cabinet, said an official at the Ministry of Finance.
Therefore it is hard to see if such a decision would be changed again, said the official, who declined to be identified.
The date when the changes would go into effect has not been decided, although it would be this year, he added.
Japan is struggling with the biggest debt burden of any industrialised country, at some 140% of gross domestic product, and the government is keen to widen its tax base.
Under the current tax rules, capital gains are not subject to a withholding tax if investors do not have a permanent establishment in Japan which many of these funds do not.