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.