I receive documents in UTF-8 which may contain pound signs correctly
  encoded as &163;. I need to style these into ASCII and so my style sheet
  defines the output encoding -   <xsl:output method="xml" indent="yes"
  encoding="ISO-8859-1"/>. 

That's latin1 not ascii
(ASCII is for people who think that "pound" means "#" and does not
include a pound (sterling) symbol.)

  the sequence EF BF BD 

Sounds like a bug but you may be able to use
 encoding="US-ASCII"/>
so that the output really is ASCII, then pound signs will be output as
as a character reference such as &#A3; which may work better.

So long as your input file isn't being corrupted when moving between
systems.

For example your mail has the line

on two platforms  one Windows,

which looks like

on two platforms \226 one Windows,

on my email reader which displays unprintable characters in octal.
octal 226 is byte 150 which is a non printing control character in
iso-8859-1 (I believe it may be something else in a windows code page)

David

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