Gov. Gavin Newsom has signed updated versions of various proposals in the May revision to his 2026-2027 budget proposal. The budget package includes several new tax proposals that could affect a broad range of taxpayers. (See our previous Alert: Revised California Budget Would Change Business Credit Limit, Taxation of Digital Software.)
The 2026-2027 budget includes total spending of almost $352 billion and more than $5 billion in new revenue. The key budget package provisions expected to contribute to that revenue increase are a permanent business credit limitation (S.B. 122), a digital software tax (S.B. 122), and a revised managed care organization (MCO) tax (S.B. 125).
Key Changes to California’s Tax Code
Tax Credit Limitation
S.B. 122 extends the temporary $5 million cap on business tax credits to tax years beginning before January 1, 2030. For tax years beginning on or after that date, the allowable credit is limited to the greater of $5 million or 70% of the company’s tax liability. Those changes have been estimated to raise $1 billion in 2026-2027, growing to more than $4.5 billion through 2029.
The limitation would not affect the refundable credit election under S.B. 175, which allows a taxpayer to make an irrevocable election on an originally and timely filed return for tax years 2024 through 2026 to receive a refundable credit equal to 20% of qualified credits exceeding the $5 million limitation. (See our previous Alert: California Enacts Significant Changes, Including NOL Suspension and Credit Limitation.)
Digital Software Taxation
Beginning January 1, 2027, California will apply sales and use tax to sales of digital products, defined as digital prewritten software transferred electronically or via tangible storage media or accessed remotely. Software delivered by electronic transmission; local hosting; or remote access through the internet, such as software as a service (SaaS), is included; custom software is not. S.B. 122 carves out products not considered digital products, including digital assets and digital visual, audio, or audiovisual works. (See our related Alert: California Moves to Subject Digital Prewritten Software to Sales and Use Tax.)
The state has estimated that the change will increase general fund and local revenue, respectively, by roughly $450 million and $560 million in the 2026-2027 window and $900 million and $1.11 billion thereafter.
S.B. 122 also establishes a $5 million sales threshold that once met, relieves a retailer of its liability to collect tax on sales of remotely accessed or electronically delivered digital products. Above that threshold, the purchaser becomes liable for use tax and must self-assess and remit.
The change would also affect technology transfer agreements because the software portion of such agreements would no longer be treated as intangible property and would therefore be subject to tax.
MCO Tax
The original budget noted that the state’s MCO tax is inconsistent with the One Big Beautiful Bill Act, which prohibits taxes that impose higher rates on Medi-Cal plans than commercial plans or that otherwise place a disproportionate tax burden on Medi-Cal plans.
S.B. 125, signed as part of the budget package, imposes on defined health plans an MCO provider tax of $8.85 per enrollee per month between 2027 and 2029. The tax is expected to create general fund savings of just over $4.5 billion over a three-year budget window. Revenue will be deposited in the Medi-Cal Stability Fund, established by the bill.
The legislation requires the state’s Department of Health Care Services to request federal approval of the tax and outlines procedures should the tax be rejected or deemed noncompliant with federal law.
- The bill provisions will become inoperative on January 1, 2031, and be repealed January 1, 2032.
BDO Insight
- Now that the budget has been approved, taxpayers should begin preparing for the tax law changes, particularly if they operate in industries or groups that will be affected. They should consult with tax advisors to determine any possible practical impact and for suggestions on how to become or remain compliant.
- For technology companies, software providers, SaaS vendors, and purchasers of cloud-based solutions, the digital software provisions could require significant operational changes before the January 1, 2027, effective date. Businesses should begin reviewing customer contracts, invoicing practices, sourcing methodologies, and exemption documentation processes.
- Similarly, companies with significant California credit carryforwards should model the impact of the permanent credit limitation on projected cash tax liabilities, deferred tax positions, and the timing of future credit use.
- Taxpayers should also monitor subsequent administrative guidance from the California Department of Tax and Fee Administration and the Franchise Tax Board because additional clarification will likely be needed regarding sourcing, software classifications, bundled transactions, and application of the new credit limitation rules.
Please visit BDO’s State & Local Tax Services page for more information on how BDO can help.