The Department of Agriculture has proposed that horse breeders receive generous tax allowances as a substitute for the current tax-free status for stud fees, which is to be scrapped by the Government.
Minister for Finance Brian Cowen last week wrote to European Agriculture Commissioner Marian Fisher Boel confirming that the Government would be addressing the issue in December's Budget.
The commission warned Mr Cowen last year of its belief that the tax exemption was an unapproved state aid, and therefore illegal under European law.
Mr Cowen refused to outline in the letter what proposals he would be announcing, but The Irish Times understands that the scheme will be scrapped and replaced with tax allowances.
Officials from the Department of Finance and the Department of Agriculture have begun discussions on a possible replacement for the tax-free scheme, which are described as being in their very early stages.
It is believed, however, that providing any blanket tax-free allowance to the industry has been ruled out as it would also be against state aid rules.
It had been suggested that an allowance capped at a certain level might be acceptable, but the European Commission has advised that no more than €3,000 could be earned tax free in any one year under this system.
The Department of Agriculture has made one proposal to replace the tax-free status with generous depreciation allowances that would allow breeders to write off the cost of purchasing stallions over a relatively short period against stud-fee income.
Sources in Brussels have indicated that the commission will be pushing the Government to scrap the current scheme as soon as possible.
Any new proposals will also need commission approval before they can be introduced.
Meanwhile, Ms Fisher Boel is due to meet today with representatives of the Irish bloodstock industry, who are campaigning to have the current tax-free regime retained.
The industry has claimed that the status, introduced in the late 1960s, has led to Ireland becoming a world leader in racehorse breeding.
A report commissioned by the breeding industry claimed that the scheme was costing €3 million in lost tax, a figure that has been disputed by some Opposition politicians.