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3.7.1.4 says: [For the purpose of identifying boundary whitespace], characters generated by character references such as   or by CdataSections are not considered to be whitespace characters. So, conceptually at least, boundary whitespace must be handled before character references and CdataSections are expanded. Therefore, I think 3.7.1.3 would be slightly clearer if the handling of boundary whitespace were addressed by a point between 1a and 1b, rather than a sentence in 1c. E.g.: b. If the boundary-space policy in the static context is 'strip', boundary whitespace is identified and deleted. (I'm pretty sure this would allow you to delete the boundary-space sentence in 1c.)
On July 20, 2005, the XQuery working group accepted your suggestion. The suggested changes will be made (however, note that these changes will interact with another editorial suggestion that has caused the rules in Section 3.7.1.3 to be renumbered.)