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In the "changes since" appendix: "An error in version 1.0 of this specification relating to the construction of union types from other union types has been corrected. Unions may now appear as members of other unions, and all restrictions of unions are correctly enforced, even when xsi:type is used on an element to name a member of the union." As I understand it, rather than having a correct enforcement of a restriction on unions when xsi:type is used to name a member of the union, the specification prevents this. Assuming that the restriction was not pointless (it has some facets), by 2.2.4.3 of 3.16.6.3 Type Derivation OK (Simple), none of the member types can be said to validly derive from the restriction. That makes using xsi:type to specify a member type illegal. It would also be helpful to point to where the specification was changed, or what the implications of getting rid of flattening for {memberTypes} are (see for example, bug 2233). Was it only to prevent a memberType from being considered as deriving from a restriction?
Resolution in http://lists.w3.org/Archives/Public/www-xml-schema-comments/2009OctDec/0007.html
A wording proposal intended to resolve this issue (and two others) has been prepared by the editors and is now on the W3C server at http://www.w3.org/XML/Group/2004/06/xmlschema-1/structures.b7787.html (member-only link)
On the telcon
The wording proposal mentioned in comment 2 and adopted today (as noted in comment 3) has now been integrated into the status-quo drafts on the W3C server. Accordingly, I'm marking this issue 'resolved'. Bugzilla should send a notice of this status change to Kevin Braun, as the originator of the issue. It would be helpful if you could review the wording change (I believe you have member access to the W3C site; correct this misapprehansion if you don't), and indicate by closing (or reopening) the issue whether you are satisfied with the disposition of the comment or not. If we don't hear from you in the next two weeks, we'll assume you are happy. Thank you in any case for the comment.