Oh, goodness! I identify with your decor dilemmas, as I, too, have a teeny tiny "powder room" (except it also has a shower...). You can see the reveal of ours here http://www.harbourbreezehome.com/2011/03/tin...
My favorite (and most practical!) part was installing shelves above the toilet for storage. Have fun!
paint! use chair rail but paint bottom white and pick a color for top... looks like paneling so if she wants the difference, use a caulk (like to fill picture holes) to fill grooves on top. Hang that basket on the wall and roll the hand towels or wash clothes...I would stick to medium to light beige in tile and white, since it is a small room. good luck
Declutter. Build a couple of shelves about 3' up over the back of the toilet, then use baskets, etc. to store things in. That along with wall color changes and perhaps chair railing should help out. The chair rail will call attention to the horizontal, making the room look larger. I also think some puck lights (over the sink) and under one of the shelves would help as well.
I just finished painting similar paneling in my den & just painting it makes a huge difference. I'd prime and paint it a pretty shade of whatever she likes and paint the trim white. Just painting that paneling will give it a cottage feel.
Did you see the hometalk post about the beadboard wallpaper. Looks like the real thing but much easier to work with. There is a link to a blog that details how to install it. This might be a great inexpensive product to use.
Coated out in a fresh neutral would be gorgeous with all that wall panel detailing! My suggestions for vintage finds is to simply hunt until you fall in love with something that speaks to you. Think in terms of towel bar, shelving, what could frame out a mirror... I never know what I'll do until I find it.
I saw the comment about the chair rail...That would be good. Also I'd paint the upper and lower parts 2 shades of a color I liked, a darker on the bottom and lighter on the top.
My favorite (and most practical!) part was installing shelves above the toilet for storage. Have fun!
Donna