There is no reason why the encoding in the output should bear any relationship to the encoding in the input.
XSLT 1.0 states: "The xml output method should output an XML declaration unless the omit-xml-declaration attribute has the value yes. " It's only a "should", not a "must", but you're supposed to obey a "should" unless you have specific reasons not to, and it's not clear what those reasons might be. Complain to the vendor or use a different processor.
Michael Kay
http://www.saxonica.com/
Author, XSLT Programmer's Reference and XPath 2.0 Programmer's Reference