The European Commission has begun proceedings against the Government over An Post's €40 million social welfare contract.

The development follows a complaint by a US company, Transaction National Services, which wanted the 1999 contract put to public tender.

It is a setback to the State company, whose post office division lost €13.1 million last year on revenues of €107.6 million. The company's overall operating loss of €6.7 million last year was the first since 1991 and it projects a €37 million deficit this year and a €27 million deficit in 2003.

An Post's chief executive, Mr John Hynes, said last week that the company wanted to see the outcome of the complaint before seeking an increase in the tariff, or level of fees it gets, for handling the social welfare business.

The action by the European Commission means the process of increasing the tariff on the social welfare contract will be delayed.

The Commission expressed concern late last week about the award of the contract, which has been renewed only on an ad hoc basis after the Transaction National Services complaint.

A spokesman for the Internal Market Directorate General at the Commission said the Government had been given two months to respond to its queries.

He said: "I can confirm that we have had a complaint and that it is something we have been looking at for a couple of years. Last week, the Commission decided to open infringement proceedings against Ireland and sent a formal letter of notice to the Government. We think that there might be a problem concerning the contract."

The Commission had written to the Government after it met last Wednesday, he said. Its discussion followed a detailed examination of the contract.

The spokesman said: "The Commission has not decided whether or not it thinks there was a violation of community law. But we're sufficiently concerned so as to open this formal procedure."

He added: "Basically, the Commission at this stage does not think that the contract should have been advertised under the Directive on the Procurement of Services, number 9250-EEC. There's lots of different services and we don't think it falls into that annex.

"We do think, however, that it should nevertheless have been advertised to allow other countries express an interest under the terms of the Treaty rules on non-discrimination on grounds of nationality and the free movement of goods and services. So the jury is out."

The development could have serious implications for the State company, whose losses last year came despite a 9 per cent increase in revenues to €625 million.

Social welfare payments made up about 37 per cent of post office business in revenue terms and the company is thought to want the Department of Social, Community and Family Affairs to increase the tariff it pays by about 10 per cent.

In the company's annual report, Mr Hynes said the number of social welfare transaction payments had declined by 2.35 per cent last year, mainly due to migration to electronic payments. The tariff had not been increased since 1996, he noted.

He said: "The loss [at the post office division] was driven by two key factors: the increasing costs of operating the post office branch network and a failure to achieve price increases on core contracts."

Price increases were "justifiable and overdue" and they would be pursued vigorously.

The company disclosed last week that losses on its postal and post office monopoly businesses were being subsidised by profits on elements of the business that were subject to competition.

The social welfare contract is one of three main revenue drivers for the post offices division, which is forecast to lose another €13 million this year.

The company operates and markets savings and investment products as an agent of the National Treasury Management Agency.

It also sells television licences for RTÉ and monitors evaders. But the broadcaster is unhappy with the licence collection rate and it wants the television service put to tender. An Post rejects the complaints.

The EU spokesman declined to name the complainant, but Transaction National Services has been linked with the case since it emerged in 1999.