I got it to work when selectingx86 instead of any CPU in the target platform in the C# projectproperties.Perhaps SQLXML 3.0 SP3 only works with 32-bit compiled applications.
If you look at the properties of the reference it says that it was compiled agains .NET FW v1.0.3705. Perhaps you need .NET FW 1.x installed as well.
Cheers
Niklas