The Government is fighting proceedings taken against it by the European Commission over the award of An Post's social welfare contract.

The contract has been worth about €40 million every year to An Post but it was awarded in 1996 without being put to tender.

While the Commission is still considering its response, the view of certain informed figures in Dublin is that a confrontation in the European Court of Justice in Luxembourg is likely. Because of An Post's financial difficulties, the person said the Government was not prepared to put the contract out to tender.

In a related development, it is understood that the Government agreed in principle to increase the fee it pays to An Post to deliver social welfare payments. The company had sought a 10 per cent increase, arguing that it was losing money for providing the service.

The level of increase agreed is unclear but if a 10 per cent rise was granted the fee paid next year to An Post would rise to €44 million. This would ease some of the financial pressure on the company, although it would not be enough to wipe out the €27 million deficit projected for 2003.

The social welfare business is one of three main revenue drivers in the ailing post office division, which is projected to lose €13 million this year.

The agreement in principle comes after an advisory panel, chaired by consultant Mr Phil Flynn, said the process of reviewing the fee should be treated in isolation from the EU's scrutiny of the contract.

However, no final decision has yet been reached. An Post's spokesman said: "We are engaged in discussions with the Government about the price of the services which we provide."

A spokeswoman for the Minister for Social and Family Affairs, Ms Coughlan, declined to comment on the process because the Department's relationship with An Post was commercial.

The infringement proceedings were prompted by a complaint about the contract in 1999 by US group Transaction National Services. The proceedings followed detailed scrutiny of the contract by the Commission's internal market directorate general.

Because of the Transaction National Services complaint, the contract has been renewed on an ad-hoc basis only. When issuing the proceedings, the Commission said it was concerned about a possible violation of European Law.

But the Government has defended the process.

Ms Coughlan's spokeswoman said: "Ireland has contested the finding of the European Commission in relation to the An Post contract following legal advice received through the Attorney General's office."

She added: "This response must now be considered by the European Commission before deciding whether to proceed to the next stage, namely, the issue of a 'reasoned opinion' in the light of the views put forward in the matter. A further response from the Commission is awaited."

A spokesman for the Commission said: "The Irish Government responded to a formal request for information. We are still reflecting and considering our position. I think that probably before Christmas the Commission will decide whether this is a problem or not."

It argued that the contract should have been advertised to enable other organisations outside the State to express an interest under European Treaty rules on non-discrimination on grounds of nationality and the free movement of goods and services.

However, the Commission has stated that it believed there was no requirement to advertise the contract under the Directive on the Procurement of Services number 9250-EEC, which is the standard obliging the State to put major contracts out to tender.