Thank you Mikkel for your response. I have just added a workaround for the problem.
Set domparser = session.CreateDOMParser(xmlin, transformer)
domparser.ExpandEntityReferences = True
The property of the NotesDOMParse to expand the external entity references does the trick. Its an extra step however I can still work with my existing structure of the XML.
I wonder if anyone has another recommendation that does not involve changing the XML.