reworded section 3.3:

Each document in the interchange set MUST be represented in an SML-IF document by a separate document element as follows:

    *      Each definition document [Ed. note: insert link to definition] in the interchange set MUST appear as a child of a document element that is a child of the definitions element of the SML-IF document. The order of the document children is not significant.
    *      Each model instance document [Ed. note: insert link to definition] in the interchange set MUST appear as a child of a document element that is a child of the instances element of the SML-IF document. The order of the document children is not significant.

Documents may be included in the SML-IF document either as an embedded document (where the octet stream representing the SML model document to be included is physically embedded in the SML-IF document) or as a document reference.

3.3.1 Embedded Documents

If a document is to be physically embedded in the SML-IF document, the octet stream representing it MUST first be processed as follows:

    *      The XML declaration and document type declaration (DTD) are removed.
    *      The stream is converted to the encoding of the SML-IF document into which it will be packaged.

Note:

If the SML-IF document uses UTF-8 encoding, the octet-stream result of XML Canonicalization [Canonical XML] is more than sufficient to accomplish this processing.

The resulting octet stream MUST be embedded as the content of the data child of the corresponding document element in the SML-IF document.

3.3.2 Document References

If a document is to be referred to rather than embedded, a reference to it MUST placed in the locator child of the corresponding document element.

SML-IF specifies one way such references may be constructed, the documentURI element, however any representation the producer and consumer agree on may be used. [Ed. note: the previous statement is not very portable!]

The statement regarding the placement of the model instance document, "Each model instance document...MUST appear as a child of a document element that is a child of the instances element...", appears to be garbled.  The model instance doc is a child of the <instance> element and not the child of a <document> element.  The final clause then seems to get everything into an infinite recursion.  (There might have been a copy/paste error from the preceding statement, and the wrong words were mistaken changed.  Note the <instance> is on the same level as the <document> element.  I believe the statement should read: Each model instance document...MUST appear as a child of a INSTANCE element that is a child of the DEFINITIONS element....) 

(In reply to comment #2)
> The statement regarding the placement of the model instance document, "Each
> model instance document...MUST appear as a child of a document element that is
> a child of the instances element...", appears to be garbled.  The model
> instance doc is a child of the <instance> element and not the child of a
> <document> element.  The final clause then seems to get everything into an
> infinite recursion.  (There might have been a copy/paste error from the
> preceding statement, and the wrong words were mistaken changed.  Note the
> <instance> is on the same level as the <document> element.  I believe the
> statement should read: Each model instance document...MUST appear as a child of
> a INSTANCE element that is a child of the DEFINITIONS element....) 

I WAS SUFFERING FROM ANGLE BRACKET DYSLEXIA.  THE TEXT IS CORRECT AS PROPOSED.