The Government is being taken to court by Brussels for offering across-the-board tax cuts to encourage homeowners to make their houses more energy-efficient.
The European Commission claimed today that, under EU rules, such VAT reductions must be linked to "social policy" and warned in a statement: "The Commission is aware that the reduced VAT rate for energy-saving materials has been linked to the UK's 'Green Deal' to improve the energy efficiency of buildings.
"While it supports the objectives of the UK Green Deal, the Commission does not believe that breaking EU VAT rules will help in achieving these objectives."
Under the EU's VAT Directive, member states can apply lower-rate VAT to "the supply of goods and services used in the housing sector, so long as this is part of a social policy".
Thursday's statement announcing legal action in the European Court of Justice for breaching the rule explained:
"Energy-saving materials could be covered by this provision if the conditions are met, i.e. if they are used for social policy purposes in the construction, renovation and alteration of housing.
"However, there is no provision in the VAT Directive to allow a reduced VAT rate on 'energy-saving materials' specifically, and the universal application of a reduced rate for energy-saving materials is therefore not allowed.
"By allowing a reduced VAT rate to all energy-saving materials, the UK is therefore going beyond the scope of what is permitted under EU law."
When the VAT Directive was drawn up, the EU's national governments, who all backed it, agreed on the list of goods and services qualifying for a reduced rate and they also insisted that "the list be strictly applied, with no room for manoeuvre or interpretation", said the Commission.
This was important, insists the Commission, to prevent competitive distortions in the single market and to ensure "a fair and level playing field" between member states.
EU officials say economic studies have shown that reduced VAT rates are often not the best way to achieve policy objectives or change consumer choices.
"In the case of promoting energy efficiency, there are a number of reasons why a reduced VAT rate is not the most efficient way to deliver on this goal" said today's statement.
"For a start, it is difficult to define precisely these products, which can evolve and develop quite quickly, thereby creating uncertainty around the level of tax due.
"Moreover, a reduced rate does not target the population that needs it most, but instead is universally applied.
"In the case of energy efficient products, businesses are likely to represent a large proportion of those wishing to invest in them, in which case the VAT is deductible anyway. It has been shown that frequently reduced rates are not fully passed on to consumers in the form of lower prices."
The statement concluded: "There are other, more efficient, ways of promoting energy efficient materials while remaining in line with EU law such as through direct subsidies."
The Commission sent a formal warning - a "reasoned opinion" - to the Government last June, but said the response in August was "not satisfactory", prompting today's decision to refer the case to the Luxembourg judges.
Ironically, the legal challenge comes in the same month that the Commission approved Government aid of £600 million towards measures promoting the Green Deal policy as being in line with strict EU state aid rules.
On February 5, the Commission declared the Green Deal to be "the central UK Government policy for improving the energy efficiency of buildings" and state distortions of competition were being kept to "an acceptable minimum".
At the time EU competition policy Commissioner Joaquin Almunia said: "The UK Green Deal allows consumers and businesses to improve the energy efficiency of their buildings without making huge upfront investments.
This is another example of how our policy of state aid control can support private investment in energy saving and enhance competition at the same time."
Conservative MEP Martin Callanan, the party's environment spokesman in the European Parliament, blamed "jobsworth" officials for interfering in domestic energy strategy and said EU law should be changed, rather than Government policy.
He said: "This is a typical case of jobsworth bureaucrats who lose all common sense when they enter their ivory tower.
"The Commission cannot propose stringent and growth-hampering environmental legislation on one day, and then demand we drop a major scheme aimed at reducing energy use the next."
Callanan added: "Clearly the Commission should be proposing that the law be changed to comply with a very sensible and positive policy in the UK.
"Reducing the cost of installation of energy-saving products into people's houses is not going to seriously distort the Single Market so the Commission should relax its overzealous approach."
A HM Revenue and Customs spokesman said the Government challenged the interpretation of what was allowed under the VAT Directive - but acknowledged that the UK intended to halt the reduced rate from work on buildings only used for "charitable purposes", in response to one of the Commission's complaints.
"There has been no material change in the UK's view since August last year. We remain of the view that the reduced rate for ESMs (energy-saving materials) within residential buildings is within the scope of what is allowed under the VAT Directive.
"However, the Government has announced its intention to withdraw this reduced rate from buildings used solely for a relevant charitable purpose as part of Finance Bill 2013.
"The UK notes the European's Commission's decision to refer the United Kingdom to the EU Court of Justice for its reduced VAT rate on the supply and installation of energy-saving materials."Suggest a correction