It sounds like the automatic expansion of entities that was occuring in Notes 6.5.4 isn't kicking in anymore in Notes 7.0.2. I checked the documentation and it doesn't seem like there is any XSLT API support for explicitly working with entities through the LotusScript API as is the case when working with XML in Java.
Only place I see any mentioning of entities for LotusScript XML handling is in the NotesSAXParser and the SAX_ResolveEntity event. I would suggest looking into that event even though that has nothing to do with XSLT. Another idea would be contacting Lotus Support.
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