Found a/the solution but I have no idea why or how it works!!!
On the workstation there is a mapped drive to the application folder. On the desktop we create shortcuts with a path like g:\app\myapp, also the start in is set correctly - when the app is launched from this shortcut we have the error when mail merging to Word. Out of sheer desparation we created a shortcut to the app with the unc path ie. \\server01\shared\applications\myapp - launching the app from this shortcut gave us no problems with the merge...

Any ideas why this makes a difference???