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Also with the scenario of the PCM coming from the 1st gen PS3, would I still be able to have 7.1 coming from the AVR ?
Make sure that you have set the PS3 to output 7.1 in the output settings. I have a fat PS3 (but new enough that it doesn't support SACDs) and it sends 7.1 signals just fine to my Pioneer 9140 (all 7.1 channel lights light up, even though I only have 5.1 speakers).

Make sure that it is a 7.1 source. If I play a 5.1 source on my PS3, it will send 5.1, while a 7.1 source will be 7.1.

Also, when playing HD sources (including PS3 games) make sure the PS3 is set to output PCM. If you set it to Bitstream, it will only send lossy DD/DTS (except for the slim PS3s).
 

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My reasoning is that when I was using the BRP, it was sending the receiver these signals. Now with the fat PS3 it is sending the raw PCM 5.1 channels instead of the encoded signals. Therefore the receiver can't do its trickery and merely puts out the original 5.1.
The receiver should be able to matrix 5.1 into 7.1. On the front of the receiver, do the lights (the ones that show how many channels the receiver is receiving) show 7.1 or 5.1 ?

I wonder if the PS3 is sending 7.1 channels, but only filling 5.1 of them -- if the PS3 is sending blank rear surrounds, there would be nothing the receiver could do about it. Do you have 5.1 output enabled on the PS3? If not, enabling it may help (so that 5.1 signals are sent as 5.1 rather than embedded in 7.1).
 
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