California Redefines Licensed Software as “Tangible Property” for Sales Tax Purposes

California Extends Sales and Use Tax to Software and SaaS

On June 29, 2026, Governor Newsom signed SB 122, which expands California sales and use tax to cover prewritten computer software regardless of delivery method, effective January 1, 2027. Previously, only software delivered on physical media was taxable. Software delivered electronically or accessed remotely, including software as a service (“SaaS”) and cloud-based software, was not. For example, Microsoft 365, which provides subscription access to Word, Excel, and PowerPoint, and many AI applications are SaaS products that will now be subject to California sales and use tax. Thus, these products will cost more due to the new tax. Businesses that purchase or sell software in California should begin preparing now, even though key implementing regulations have not yet been finalized.

Definitions

SB 122 expands California sales and use tax liability to “digital products” and any associated copyright or patent interests. A “digital product” is prewritten computer software transferred on tangible storage media, transferred electronically, or accessed remotely. This definition captures SaaS, subscription software, and other hosted offerings previously not taxable. “Prewritten computer software” is software held for general or repeated sale or lease regardless of whether it is initially developed on a custom basis or for in-house use. “Tangible storage media” includes drives, disks, memory cards, or similar devices. A product is “transferred electronically” when a purchaser obtains it by means other than tangible storage media and “accessed remotely” when a purchaser uses a digital code, password, or similar means to access software on the vendor’s or a third-party server.

Certain categories are excluded from “digital product” and are not taxable: (1) digital assets (cryptocurrency and blockchain-based tokens); (2) digital audio works (music and podcasts); (3) digital audiovisual works (movies and television); (4) digital books (e-books); (5) digital infrastructure (cloud computing and IaaS that allows users to run their own software without managing underlying infrastructure); (6) digital video game products; and (7) digital visual works (digital art).

SB 122 also amends the definitions of “sale,” “purchase,” and “use” for digital products. With limited exceptions, sales and purchases do not include transactions involving custom computer software, which is computer software prepared for the special order of a single customer and includes those services represented by separately stated charges for modifications to existing prewritten computer software that are prepared specially for the customer. Modifications to prewritten computer software to meet a customer’s needs qualify as custom computer software only to the extent of the modification. Because custom software is excluded from the definitions of “sale” and “purchase,” businesses that can structure engagements as true custom development or separately state custom modification charges may avoid sales tax. “Use” includes the exercise of any right or power over property incident to ownership, and for digital products specifically includes opening, viewing, accessing, downloading, copying, updating, possessing, storing, or manipulating the product. However, “storage” and “use” do not include keeping or deploying a digital product for use solely outside California.

Exemptions

SB 122 creates several exemptions from both sales and use tax. First, digital products purchased solely for use outside of California are exempt from sales tax and use tax. Second, SB 122 exempts from sales and use tax the right to reproduce or copy a digital product in order for copies to be distributed for consideration to third parties, including in cases where a copy is transferred concurrently with the granting of that right. Third, apart from SaaS access rights, SB 122 exempts digital products that are electronic services provided by the service provider through the application of its own efforts and that originated after the customer requested the service.

Sourcing Rules for Digital Products

SB 122 establishes sourcing rules for the sale and purchase of digital products. Products transferred on tangible storage media are sourced to the location where the media is physically located at the time of sale. In-person sales of electronically delivered products are sourced to the seller’s California place of business. All other sales are sourced to the purchaser’s “known address” in California as shown in the seller’s records, determined in the following priority: (1) billing address, (2) shipping or delivery address, (3) address associated with payment instrument, or (4) other mailing address. If no California address can be determined, the sale is deemed to occur outside California.

In addition, for use tax purposes, the place of use is where any right or power is exercised over the product. The right to remotely access a digital product is exercised where the person accessing it is located. A digital product purchased outside California and used in California within 90 days is presumed to have been purchased for use in California.

Collection and Payment Obligations

SB 122 shifts collection responsibility from retailers to large purchasers once a threshold is reached. When a retailer’s aggregate gross receipts from sales of electronically delivered or remotely accessed digital products to a given purchaser exceed $5,000,000 (to be adjusted for inflation in future years) in the current calendar year, the retailer is relieved of the obligation to collect sales tax, and the purchaser must self-assess and remit use tax directly to the California Department of Tax and Fee Administration (the “CDTFA”). This shift of collection responsibility to large purchasers presents significant compliance obligations for organizations with substantial software spend.

Key Implementation Questions

The CDTFA has not yet issued implementing regulations. Until then, several significant questions remain unresolved:

• How does “digital infrastructure” differ from taxable SaaS? The line between excluded digital infrastructure and taxable SaaS may be unclear, particularly for platforms combining infrastructure with application-layer features.
• How should bundled transactions, maintenance agreements, and implementation charges be treated? SB 122 does not address how to allocate bundled transactions that include taxable and nontaxable components, how maintenance agreements should be treated, or whether separately stated implementation and training charges are taxable.
• Where is the line between custom and prewritten computer software in a SaaS context? The line between custom computer software and prewritten computer software may be difficult to draw in a SaaS environment where platforms are often configured for each customer but built on a common codebase.
• What constitutes a “modification” for purposes of the custom computer software exclusion? Sales and use tax generally does not apply to those services represented by separately stated charges for modifications to prewritten computer software prepared to the special order of the customer, but only to the extent of the modification. What types of changes qualify as a “modification” is not defined by the statute.
• What qualifies as a service primarily involving human effort? This may be difficult to determine where a provider concurrently delivers automated software functions and human-performed services.
• How can the 90-day use presumption be rebutted? A digital product purchased outside California and used in California within 90 days is presumed to have been purchased for use in California. The statute does not specify what evidence is required to rebut this presumption or how businesses should document out-of-state use.

Compliance Issues

Businesses that purchase or sell software in California should take several steps now to prepare for January 1, 2027. With combined state and local rates ranging from approximately 7.25% to over 9%, the cost impact may be substantial for organizations with significant software spend.

1. Identify digital products. Catalog software subscriptions, licenses, and SaaS purchases to determine whether each is a taxable digital product, an excluded category, or exempt custom computer software.
2. Assess exemption certificates. Determine whether sales or purchases qualify for an exemption and prepare or obtain exemption certificates as appropriate.
3. Confirm sourcing. Confirm that billing systems collect accurate purchaser address information to support sourcing determinations and evaluate how multi-state enterprise licenses will be apportioned.
4. Evaluate multi-state license apportionment. For digital products concurrently available for use in multiple locations, CDTFA may prescribe alternative methods to calculate tax. Businesses with enterprise-wide licenses should evaluate how to apportion taxable use between California and other states.
5. Review customer agreements. Examine existing agreements for tax passthrough or gross-up clauses that could automatically pass the new cost through.
6. Model tax impact. Estimate the additional tax cost based on the digital products identified and the sourcing analysis.
7. Monitor CDTFA guidance. Watch for CDTFA emergency regulations and further guidance on the implementation of this statute.

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This alert is intended to provide general information and does not constitute legal advice. Please contact a member of our tax team to discuss how these changes may impact your business.