I was impressed by the demos I saw at PyCon of IronPython and Silverlight. IronPython is Microsoft's open source implementation of Python for the .Net Common Language Runtime (CLR). Silverlight is, essentially, Microsoft's Flash rival. Silverlight is not open source, but Novell is working on an open source implementation called Moonlight.
I can't help but wonder how an implementation of Sugar based on Silverlight would work. In particular, it is hard not to also wonder what an XO running a CLR based operating system would act like, as Chris Dawson has suggested. Of course, such a thing doesn't exist, although there are some very immature attempts (Singularity, Cosmos, SharpOS). It seems to me that Microsoft needs a greenfield OS project. They need to mothball XP, and all these cheap laptops that can't run Vista will just drag them down further.
The tricky thing here is that Microsoft could work with Novell to provide both proprietary Microsoft and open source versions of this stack, virtually ensuring their tools remain at the center of this not terribly profitable, but potentially strategic market segment.
Back in reality, Sugar is already demonstrating the difficulty of pulling off a greenfield desktop environment, even without writing a new OS at the same time, and Microsoft seems no more capable of pulling off this sort of move than, say, General Motors does, so I don't expect it. Just had to get the idea off my chest.