Its working upstream because it is not intended to work the way I believe you expect.

The Files->Replace tabs with space is a change that is made at file saving (as the heading says) not to the buffer.

And has nothing to do with the default indentation, so Project->Apply default indentation won't be affected, its affected by the Editor->Indentation type but that sets what is to be input for new indentation, it doesn't affect existing spaces and tabs. The Apply default indentation applies the setting to all files to save you time, but its still the setting for new indents, not a command to change existing indents. Existing spaces and tabs are changed by Document->Replace tabs with spaces.

Basically the settings for new input are separated from the actions to change existing file content because otherwise its impossible to make files with mixed indents (don't ask me, but some people seem to need/want them).

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