I am going to paint the interior of my NE Dory however I want to varnish the rubrail/spaced inwales and was curious how others have done it. My quesion is do i paint the space between the spacers and if so should they be painted before adding the inwale? [pic is borrowed from Dave Metcalf's blog]

A 1" foam brush fits very nicely in those spaces after the inwale is attached. I varnished that area on my Skerry, and it was no big deal, except that I did not sand there between coats.
But I epoxied and sanded the blocks and the inner face of the inwale before attaching the inwale, just like CLC's article on spacered inwales suggested.