HM Customs and Excise (HMCE) is considering making electronic VAT returns compulsory for some companies within the next three years, in order to deliver the cost savings promised as part of its £1bn IT improvement programme.

HMCE signed a £929m infrastructure deal with Fujitsu Services which runs until 2009.

But if it is to reap the cost savings it promised in order to get the funding, HMCE will need more than half of UK businesses to file VAT returns electronically.

This is a tough target. A previous e-VAT trial attracted less than one per cent of eligible companies.

And senior HMCE officials have admitted that small businesses may be reluctant to move away from the relatively easy to use paper-based system.

Michael Eland, acting chairman of HMCE, told the Public Accounts Committee that it was considering incentives to encourage take-up, but may enforce electronic filing on certain firms.

"We will look at a mandatory scheme in some areas, for certain types of business. We're looking to get 50 per cent take up by March 2006," he said.

This is most likely to be aimed at large companies with sophisticated IT systems, as Eland acknowledged the problems of persuading smaller firms of the benefits.

But Eland confirmed that a new pilot scheme, due to be launched in June 2004, has already slipped two months behind schedule because of software faults.

MPs were critical of HMCE's e-delivery programme, calling for tighter boundaries governing when IT services contracts should be re-tendered rather than just renegotiated.

HMCE originally paid Fujitsu Services £500m for a 10-year IT infrastructure deal in 1999. This was renegotiated two years later, with the price rising to £929m.

Government watchdog the National Audit Office suggested that final costs were likely to exceed £1bn.

Eland insisted that costs were unlikely to rise significantly, pointing out that they had been incured because HMCE had bought more services from Fujitsu.

With the government's trusted trouble-shooter Gus O'Donnell currently reviewing the operation of HMCE, Eland's insistence that costs will not rise could be significant.

One option O'Donnell is known to be considering is merging the department with the Inland Revenue.

Combining both departments' IT systems will be a lot easier, as Fujitsu is part of the consortium that won the Revenue's outsourcing contract last week.

Edward Leigh, chairman of the Public Accounts Committee, said that HMCE's cost benefit analysis was "wildly optimistic" but critical if the department was to benefit from the e-VAT project.