As part of California’s 2026-2027 budget, Gov. Gavin Newsom has signed S.B. 122, which will apply sales and use tax to digital prewritten software, including software as a service (SaaS), beginning January 1, 2027. The state estimates the change will contribute about $900 million to the general fund and raise $1.1 billion in local sales tax revenue annually (roughly $2 billion combined).
S.B. 122 imposes sales and use tax on retail sales of digital prewritten software, including SaaS, regardless of how it is delivered (physical media, electronic download, or remote access). Custom computer software, or software prepared to the special order of a single customer, remains exempt. Modifications to prewritten software qualify as custom only to the extent of the modification, and only if the charges for those modifications are separately stated.
Services related to SaaS remain exempt if they primarily involve the application of human effort that originates after the customer requests the service. That exemption does not reach the SaaS itself — that is, cloud software the customer accesses through a browser, thin client, or program interface. The new tax reaches prewritten software only: The definition of the term “digital product” expressly excludes digital assets such as cryptocurrency; digital audio, visual, and audiovisual works; digital books and video games; and digital infrastructure such as infrastructure as a service-type platforms.
Sales of digital prewritten software are sourced to the purchaser’s known California address shown in the seller’s records, applied through a priority order: billing address, then shipping or delivery address, then the address tied to the payment instrument, then mailing address. If the seller has no California address, the sale is sourced outside the state. A digital product purchased outside California and used in the state within 90 days is presumed to have been purchased for use in California.
A retailer is relieved of liability to collect tax on remotely accessed or electronically delivered digital products sold to a purchaser once gross receipts from those sales exceed $5 million in the aggregate for the calendar year (the current year and, beginning in 2028, the current or preceding year). Above that threshold, the purchaser becomes liable for use tax and must self-assess and remit it directly to the California Department of Tax and Fee Administration (CDTFA). Software purchased solely for use outside California, or in interstate or foreign commerce, is exempt.
S.B. 122 also changes the treatment of technology transfer agreements (TTAs). Because the bill adds digital products and any associated copyright or patent interests to the definition of tangible personal property, the software component of a TTA is no longer treated as nontaxable intangible property. The right to reproduce or copy a digital product for distribution to third parties for consideration remains exempt, and any tangible storage media used to transmit it is merely incidental. Gray areas remain — notably for platform as a service (PaaS), which sits between taxable remotely accessed software and the excluded digital infrastructure category, and future products and services the statute does not contemplate. Much operational detail is left to the CDTFA, which has emergency regulatory authority.
BDO Insights
- Companies that buy or sell digital prewritten software or SaaS should prepare now for the January 1, 2027, operative date. Practical steps include:
- Mapping revenue streams and purchases to taxable prewritten software and SaaS versus exempt custom software, services, or excluded digital products;
- Reviewing customer contracts for tax pass-through or gross-up language and confirming by California purchaser address that billing systems can apply tax;
- Modeling the $5 million threshold and the resulting use-tax self-assessment obligations for large software relationships;
- Documenting custom software status and separately stated modification charges, along with exemption support for out-of-state use; and
- Modeling the sales tax cost together with S.B. 122’s business credit limitation ($5 million or, beginning in 2030, the greater of $5 million or 70% of tax liability), which affects credit-heavy taxpayers.
- Unlike New York and Texas, which provide multipoint use frameworks allowing purchasers to allocate a subscription price based on where use occurs across states, S.B. 122 includes no comparable allocation mechanism, leaving sellers and multistate buyers without statutory guidance on how to apportion the California-taxable portion of a multistate license or subscription pending CDTFA regulatory action.
BDO’s State & Local Tax team can help assess exposure and build a compliance plan. Please visit BDO’s State & Local Tax Services page for more information on how BDO can help.