California Expands Sales Tax to SaaS and Digital Products Beginning January 1, 2027
California businesses that sell, license, purchase, or use software should start preparing now for a significant change to the state’s sales and use tax rules.
Effective January 1, 2027, California Senate Bill 122 extends sales and use tax to certain digital products, including many software as a service (SaaS) and remotely accessed software arrangements that historically were not taxable in California. The new rules generally apply to taxable prewritten software regardless of whether it is delivered on physical media, downloaded electronically, or accessed remotely.
The change affects both companies selling software into California and businesses buying software for use in the state.
Who Is Affected by California SB 122?
Businesses should review the new rules if they:
- Sell prewritten software or SaaS to customers in California
- License software or give customers remote access to prewritten software
- Purchase SaaS, hosted applications, or other remotely accessed software for employees or operations in California
- Sell taxable digital products into California from another state
- Have significant digital product transactions with a single customer that could exceed the $5 million threshold discussed below
Under the new rules, the delivery method does not determine whether software is taxable. Prewritten software may be taxable whether it is provided on physical media, downloaded, or accessed remotely through a browser, application interface, password, code, or similar method.
Is SaaS Taxable in California Starting in 2027?
In many cases, yes. One of the most important parts of SB 122 is its treatment of remotely accessed prewritten software.
Businesses should not assume software falls outside California sales tax simply because nothing is downloaded or physically delivered. The new rules specifically include prewritten software that customers access remotely, which can include:
- SaaS subscriptions
- Hosted applications
- Other arrangements that give customers access to prewritten cloud software
Review both the software itself and the underlying contract before deciding how a transaction should be taxed.
What Digital Products Are Not Taxable Under SB 122?
SB 122 does not make every digital transaction taxable. The law and current California guidance identify several exclusions and exemptions that may apply, depending on the facts.
| Category | How it is treated |
|---|---|
| Custom software | Qualifying custom computer software, other than a basic operational program, is exempt. |
| Certain electronically delivered services | May be exempt when the service primarily involves human effort by the provider and the work begins after the customer requests it. This does not apply simply because human services are provided alongside access to prewritten cloud software. |
| Excluded digital items | Digital assets, digital audio works, digital audiovisual works, digital books, digital infrastructure, digital video game products, and digital visual works are excluded from the definition of digital products. |
| Sales for resale | Not subject to sales tax when the seller timely accepts a valid resale certificate in good faith. |
| Use outside California | A digital product purchased solely for use outside California, or in qualifying interstate or foreign commerce, may be exempt when the required conditions are met. |
Before relying on any exemption, review the specific terms of the agreement and how the product is actually used.
What Are a Seller’s Responsibilities Under SB 122?
A retailer selling taxable digital products for use in California generally must:
- Register with the California Department of Tax and Fee Administration
- Report and pay sales tax or collect use tax
- Maintain appropriate records
- Properly allocate applicable local and district taxes
These obligations can also apply to an out-of-state retailer that is considered to be engaged in business in California.
For businesses selling software nationally, California customer locations and transaction details become far more important. Many software companies will need to bring sales tax into the same multi-state tax compliance process they already use for income and franchise taxes.
What Are a Purchaser’s Responsibilities Under SB 122?
Buyers have obligations too. A business may need to report and pay California use tax directly when:
- The retailer does not collect the appropriate tax
- The purchaser previously gave an exemption certificate but later makes taxable use of the product in California
- The $5 million direct payment threshold applies
Companies buying SaaS or remotely accessed software should confirm whether their vendors will begin collecting California tax in 2027.
How Does the $5 Million Direct Payment Threshold Work?
SB 122 includes a specific rule for large transactions between one retailer and one purchaser.
- In 2027: once aggregate qualifying sales by a retailer to the same purchaser exceed $5 million, responsibility generally shifts to the purchaser, beginning with the transaction that causes the threshold to be exceeded.
- From January 1, 2028: the current or preceding calendar year is considered when determining whether the threshold is met.
- Going forward: the threshold is subject to future inflation adjustments.
When the threshold applies, the purchaser generally must:
- Obtain a Use Tax Direct Payment Permit
- Give the retailer a Use Tax Direct Payment Exemption Certificate
- Report and pay the applicable state, local, and district use taxes directly to California
Businesses with large software contracts should start identifying vendor relationships that could approach this threshold.
How Does California Source Digital Product Sales?
California has specific rules for determining where a sale of an electronically transferred or remotely accessed digital product takes place.
Sales tax: where the sale occurs
For remote sales, the place of sale is generally the purchaser’s known California address in the seller’s records, maintained in good faith in the ordinary course of business. If the purchaser provides more than one address, California applies a priority order that generally starts with the billing address, followed by the shipping or delivery address, then the payment instrument address and other mailing addresses.
If no California address is available under these rules, the sale is generally treated as occurring outside California.
Use tax: where the product is used
For use tax, the question is where the digital product is used. For remotely accessed products, businesses should consider where users actually access the software, particularly when employees or other users are spread across several states.
Accurate customer addresses, employee locations, user information, and usage records become essential for any business operating in more than one state.
What Does SB 122 Mean for Financial Services Companies?
Financial services firms sit on both sides of this change.
- As buyers: mortgage lenders and servicers, banks, asset managers, and broker-dealers rely heavily on SaaS, including loan origination and servicing platforms, portfolio and fund accounting systems, compliance tools, and CRM software. Large enterprise contracts can approach the $5 million direct payment threshold, and users are often spread across several states.
- As sellers: financial technology companies and specialty finance businesses that license platforms or provide software access to partners and customers may now be selling a taxable digital product.
- For both: bundled contracts that combine software access with servicing, data, or advisory work need careful review, because human services sold alongside prewritten cloud software do not automatically make the transaction exempt.
What Should Businesses Do Before January 1, 2027?
Use this checklist to prepare:
- Inventory your software. Identify prewritten software, SaaS subscriptions, hosted applications, and other remotely accessed software your company sells or buys.
- Classify each product. Determine how it is treated under the new rules and document the basis for any exemption or exclusion.
- Review contracts and invoices. Look at bundled software and service charges, customer addresses, tax provisions, and separately stated fees.
- Map where users are. Identify where employees and other authorized users actually access enterprise software, especially for multi-state contracts.
- Ask your vendors. Confirm whether each software vendor plans to collect California sales or use tax beginning in 2027.
- Build a use tax process. Set up a routine for identifying and reporting use tax when a vendor does not collect it, and make it part of your internal controls over financial reporting so the liability is accrued consistently.
- Track large relationships. Monitor digital product purchases from each vendor against the $5 million direct payment threshold.
- Keep the records. Retain contracts, invoices, product descriptions, exemption certificates, address and usage records, allocation workpapers, and evidence of tax paid.
Is More CDTFA Guidance Expected?
Yes. California’s guidance in this area is still developing.
The CDTFA has indicated that it is preparing emergency regulations and additional guidance on exemption certificates, direct payment procedures, waiver requests, and the reporting of local and district use taxes.
Businesses should continue monitoring CDTFA guidance before and after the January 1, 2027 effective date, as further clarification is expected as the rules are implemented.
How Cathedral Can Help
If your business sells, licenses, purchases, or uses software in California, Cathedral CPAs & Advisors can help you evaluate how SB 122 affects your current contracts, purchasing practices, sales tax responsibilities, and internal processes.
