Should your clients be investing in companies that have recently undergone a corporate inversion? Tax specialist and political analyst Andy Friedman says only if the merger between the two entities makes sense. “Investors should evaluate inversions as they would any other merger: from a business perspective first and a tax perspective second,” writes Friedman of The Washington Update fame in a recent paper, “Corporate Inversions: A Primer.”

A corporate inversion typically involves a U.S. parent company merging with a smaller company overseas, Friedman says. By combining the two companies’ operations, the U.S. company moves its headquarters to that of the overseas company, and, as a result, the parent company ceases to be a U.S. taxpayer.

Investors “should consider how well the business objectives and executive oversight of the two companies are likely to mesh, and whether there is synergistic value and cost savings to be derived by combining the two companies’ operations,” he says. “If the results of this analysis are favorable, then the tax savings are icing on the cake.”

The name “inversion,” Friedman continues, comes from turning the company upside down, with the smaller offshore unit becoming the new parent. However, the company must continue to pay U.S. tax on its operations in the U.S. “For instance, if Burger King’s merger with Tim Hortons goes through, Burger King still must pay U.S. tax on the profits generated by its U.S. locations,” Friedman says.

But by moving its headquarters overseas, a business avoids U.S. tax on its foreign income, Friedman points out.

Inversions also impose a “significant hidden cost on investors,” he says. “Under an inversion transaction as typically structured, shareholders of the U.S. company are required to recognize taxable capital gains on their shareholdings—equal to the difference between the market value of their stock and their basis—when they exchange their existing shares for shares in the new offshore parent.”

This gain recognition, he says, “is particularly burdensome because the shareholders typically receive no cash with which to pay the tax. Long-term shareholders intending to hold shares until death to receive a stepped-up basis can find their plans thwarted.”

Inversions are “a direct result” of the high American corporate tax rate, Friedman says. As a result, “inversions look less like a loophole and more like a natural reaction to a flawed tax system.” So “the proper way” to address them is to undertake tax reform, lowering the rate and simplifying the tax code.

President Barack Obama has vowed to “take action” to stop inversions, Friedman says, but it looks as though the administration lacks the power to stop inversions “outright.”

However, in mid-September, the Treasury Department and the Internal Revenue Service issued guidance to curb corporate tax inversions, and lawmakers said they would work to ensure legislation is passed to rein in such inversions.

Treasury and the IRS issued a joint notice, which they say takes “targeted action to reduce the tax benefits of—and when possible, stop—corporate tax inversions.”

The Treasury and IRS Notice does the following:

  • Prevents inverted companies from accessing a foreign subsidiary’s earnings while deferring U.S. tax through the use of creative loans, which are known as “hopscotch” loans (Action under section 956(e) of the Internal Revenue Code)

  • Discourages inverted companies from restructuring a foreign subsidiary in order to access the subsidiary’s earnings tax-free (Action under section 7701(l) of the IRC)

  • Closes a loophole to prevent an inverted company from transferring cash or property from a CFC to the new parent to completely avoid U.S. tax (Action under section 304(b)(5)(B) of the tax code)

  • Makes it more difficult for U.S. entities to invert by strengthening the requirement that the former owners of the U.S. entity own less than 80% of the new combined entity