Reken, on the same note if my relay SMTP has FQDN as host1.sun3.sub2.sub1.mydomain.com. will this cause the same 5.7.1 under 550 error is so that is the solution.. I'm running the SMTP Relay using the instructions as outlined at "How to configure an SMTP relay for Office 365" site - you posted earlier.
Regards,
Asif