At work we are being asked to create XML files to pass data to another offline application that will then create a second XML file to pass back in order to update some of ou
It is arguable either way, but your colleagues are right in the sense that the XML should be used for "markup" or meta-data around the actual data. For your part, you are right in that it's sometimes hard to decide where the line between meta-data and data is when modeling your domain in XML. In practice, what I do is pretend that anything in the markup is hidden, and only the data outside the markup is readable. Does the document make some sense in that way?
XML is notoriously bulky. For transport and storage, compression is highly recommended if you can afford the processing power. XML compresses well, sometimes phenomenally well, because of its repetitiveness. I've had large files compress to less than 5% of their original size.
Another point to bolster your position is that while the other team is arguing about style (in that most XML tools will handle an all-attribute document just as easily as an all-#PCDATA document) you are arguing practicalities. While style can't be totally ignored, technical merits should carry more weight.