Hi Dimitre,
 Please read my comments below..

It would really be a nasty bug, in case Mukul got that output.

However, what he got (note the capitalisation) was:

<AUTHOR xmlns:auto-ns1="HTTP://WWW.W3.ORG/XML/1998/NAMESPACE"
xmlns:A="XYZ" xmlns:B="PQR">

Also in the code sample he provided there is no filtering of the "xml"
namespace.

When I write the code for elements as (I have removed capitalization
within <test> tag) following:

<xsl:template match="*">
  <xsl:element name="{translate(name(), $small, $caps)}">
    <xsl:variable name="nsHolder">
      <test>
        <xsl:for-each select="namespace::*">
          <xsl:attribute name="{name()}:dummy{position()}"
namespace="{.}"></xsl:attribute>
        </xsl:for-each>
      </test>
    </xsl:variable>
    <xsl:copy-of select="msxsl:node-set($nsHolder)/test/namespace::*"/>
    <xsl:apply-templates select="@*"/>
    <xsl:apply-templates/>
  </xsl:element>
</xsl:template>

<?xml version="1.0" encoding="UTF-8"?>
<!-- THIS IS A COMMENT -->
<?PQR X="DO-SOMETHING" ?>
<AUTHOR xmlns:auto-ns1="http://www.w3.org/XML/1998/namespace" xmlns:a="xyz" xmln
s:b="pqr">
<PERSON A:AGE="30" xmlns:A="XYZ"> BY <FIRSTNAME>JANE</FIRSTNAME>
<LASTNAME>DOE</LASTNAME>,
</PERSON>
</AUTHOR>

But when I write the code as (I have now done filtering for
namespaces, with name() = 'xml'):

<xsl:template match="*">
  <xsl:element name="{translate(name(), $small, $caps)}">
    <xsl:variable name="nsHolder">
      <test>
        <xsl:for-each select="namespace::*[not(name() = 'xml')]">
          <xsl:attribute name="{name()}:dummy{position()}"
namespace="{.}"></xsl:attribute>
        </xsl:for-each>
      </test>
    </xsl:variable>
    <xsl:copy-of select="msxsl:node-set($nsHolder)/test/namespace::*"/>
    <xsl:apply-templates select="@*"/>
    <xsl:apply-templates/>
  </xsl:element>
</xsl:template>

<?xml version="1.0" encoding="UTF-8"?>
<!-- THIS IS A COMMENT -->
<?PQR X="DO-SOMETHING" ?>
<AUTHOR xmlns:a="xyz" xmlns:b="pqr">
<PERSON A:AGE="30" xmlns:A="XYZ"> BY <FIRSTNAME>JANE</FIRSTNAME>
<LASTNAME>DOE</LASTNAME>,
</PERSON>
</AUTHOR>

i.e., now the namespace http://www.w3.org/XML/1998/namespace is not
getting generated, which I think implies that it is bound to the 'xml'
prefix.

But with the earlier code, URI http://www.w3.org/XML/1998/namespace is
bound to the prefix auto-ns1.

I have tested George's code as well (the <dummy/> example he gave),
with MSXML4. I get the same output as he is getting. So MSXML4 is
generating the namespace http://www.w3.org/XML/1998/namespace bound to
prefix 'xml'.

Regards,
Mukul