California has long stood apart from many states by generally not imposing sales tax on software as a service (SaaS) and electronically delivered software, but that changes on Jan. 1, 2027.
The state is closing the gap in its sales tax base as it joins more than 25 other states that have imposed a tax on software in some form, reflecting a broader shift toward taxing digital services and electronically delivered products. For businesses that buy or sell cloud-based software, the new software sales tax California rules could affect pricing, contracts, invoicing, and compliance planning.
With Senate Bill 122, California significantly expands its sales and use tax base by expanding the definition of “tangible personal property” to include a digital product. A digital product means prewritten computer software transferred on tangible storage media, transferred electronically, or accessed remotely. The change affects all taxpayers either selling or utilizing SaaS in California.
Is Software Taxable in California? Which Digital Products Are Affected?
Prior to the passage of Senate Bill 122, California defined tangible personal property as personal property that could be seen, weighed, measured, felt, touched, or is in any manner perceptible to the senses. Senate Bill 122 expanded tangible personal property to include a digital product and any copyright or patent interest associated. A digital product means prewritten computer software transferred on tangible storage media, transferred electronically, or accessed remotely.
Here’s a look at what is becoming taxable vs. what will remain non-taxable:
Taxable
- Digital products: Prewritten computer software transferred on tangible storage media, transferred electronically, or accessed remotely.
Generally Not Taxable
- Custom software
- Certain services involving substantial human effort
- Digital asset, such as cryptocurrency or other non-fungible digital assets as specified by the secretary of the Treasury of the United States
- Digital audio work, such as music, audio books, spoken recordings, or ringtones
- Digital audiovisual work, such as movies and videos with sound
- Digital books, such as electronic books
- Digital infrastructure, such as cloud-based Infrastructure as a Services (IaaS) and Platform as a Service (PaaS)
- Digital video game product, such as a digitally downloadable game playable on a video game console or on a computer for entertainment purposes
- Digital visual work, such as computer-generated artwork
The main distinction between prewritten software and custom software is the extent the software is prepared for the special order of a single customer. Modifications to existing prewritten computer software to meet the customer’s needs should qualify as custom as long as the charges for modification are separately stated.
Will Service Offerings Become Taxable Too?
While software faces a tax, services like data processing, consulting, implementation, support, analytics, or managed services that come with software offerings may remain non-taxable when the value of the transaction primarily comes from human effort performed after the customer requests the service.
This makes it important to evaluate the “true object” of the transaction. If the customer is mainly paying for access to prewritten software, the charge is more likely to be treated as taxable. If the customer is mainly paying for a service that uses software only as a tool to deliver the service, the service component may remain non-taxable.
Separately stating service charges on contracts and invoices may become more important, so vendors can support which portions of a bundled offering are taxable and which may qualify as non-taxable services.
How California Will Determine Where SaaS Is Taxed
The law brings about new sourcing rules through the introduction of a hierarchy to source digital product sales. Software sellers should use the first available option in the hierarchy, then move down the list if needed.
- The purchaser’s billing address.
- The purchaser’s shipping or delivery address.
- The mailing address associated with the purchaser’s payment instrument.
- The purchaser’s mailing address.
Determining how much of an enterprise software license is tied to California users can be tricky for multi-state organizations, those with employees in multiple states, and/or remote workers. The question for companies with employees in multiple states becomes how to divide a SaaS subscription when employees are in different places and whether they should pay the sales and use tax on the whole subscription of only a portion of it. Any software bought for use outside of California or in foreign commerce is exempt.
Steps to Take Before California Sales Tax on SaaS Begins
Although the effective date is a few months away, businesses with California operations or customers should consider how this law change will impact them and be aware of the guidance being issued by the department. Since passing the legislation, the department has hosted and planned workshops on the subject. In advance of the interested parties meeting, the department has released several proposed regulations and amendments related to the taxation of digital products and software, including:
- Proposed Amendments to Regulation 1502, Computers, Programs and Data Processing.
- Proposed Regulation 1502.2, Custom Computer Software
- Proposed Amendments to Regulation 1507, Technology Transfer Agreements
- Proposed Regulation 1600, Application of Sales and Use Tax to Digital Products
- Proposed Regulation 1600.1, Tax Liability Thresholds for Digital Products
- Proposed Regulation 1600.2, Digital Products Purchased for Multiple Points of Use
- Proposed Regulation 1600.3, Digital Products Purchased Solely for Use Outside this State or in Interstate or Foreign Commerce
- Proposed Amendments to Regulation 1699.6, Use Tax Direct Payment Permits
To prepare for this major software sales tax change, software vendors and users can take specific action.
Providers should review their offerings and analyze which transactions would be taxable, update their billing systems, update customer contracts and invoicing, look at their procedures for tracking exemptions, and keep an eye out for any CDFTA clarification.
Purchasers should take stock of their SaaS subscriptions and tech stack, forecast their additional tax costs, review their procurement processes, evaluate their tax compliance, and identify any sourcing challenges.
For both providers and purchasers expecting to enter into or renew contracts before Jan. 1, 2027, special attention should be paid to the determination of when the sale occurs for sales tax purposes.
Proposed Regulation Section 1600(f) provides that, “the sale occurs upon any permanent or temporary transfer of the right, in any manner or by any means whatsoever, to open, view, access, download, copy, update, posses, store, manipulate, or otherwise use a digital product transferred electronically or accessed remotely for a consideration. …”
Proposed Regulation Section 1600(f) also provides a number of year-end transaction examples.
California's expansion of sales tax to SaaS and digital prewritten software is one of the state's most significant sales tax developments in years. Among the potential challenges are increased costs, more compliance requirements to track and complete, and more sales tax administrative burdens. Working with a knowledgeable sales and use tax team can help make sense of the changes and ensure compliance, especially as CDTFA is expected to give more guidance.