This problem is likely the result of an altitude loop.

Step 1 - 

Determine what kind of encoder is feeding altitude information to the AXP340.  It can be either RS-232 or Gray Code.  If it is Gray Code, we do not expect an altitude loop problem to be possible, and there is likely something else wrong with the aircraft; encoder; or the transponder itself.  If the encoder is sending RS-232 to the transponder, continue to step 2.

Step 2 -

Determine where the AXP340 is sending it's altitude information out to.  The AXP340 is designed to output (or "repeat") it's received altitude via an RS-232 output on the main connector Pin 6.  You need to determine where this output is going.  

If it is going to an IFD540/440, continue to step 3.  

Step 3 - 

Put the IFD into configuration mode, and find the RS-232 input currently configured to "Icarus Alt".  We will need to turn this input off on the IFD.  This should correct the problem.