XSLT 2.0 has an output method="xhtml".
You don't say what output method you are using or which XSLT version you are using.
Also, your output appears to have a single space as the content of the input element, but there's nothing in your stylesheet that could produce that space.
Michael Kay
http://www.saxonica.com/
Author, XSLT Programmer's Reference and XPath 2.0 Programmer's Reference