Effective January 2027, California’s sales and use tax base will significantly expand to include Software as a Service (SaaS) and other remotely accessed software companies, under Senate Bill 122 (SB 122). Prewritten computer software, under the legislation, will now generally be subject to tax regardless of whether it is delivered on physical media, downloaded electronically or accessed remotely through the internet under a SaaS or similar arrangement.

Prior to this bill, California taxed prewritten (otherwise known as canned) software delivered on tangible media but not the same software when downloaded or accessed remotely without a transfer of tangible personal property. SB 122 largely eliminates that distinction. Going forward, the method of delivery will not determine taxability in most cases. The focus instead shifts to whether the customer is purchasing taxable prewritten software.

THE APPLICABILITY OF SALES TAX ON REMOTELY ACCESSED SOFTWARE

Although the statute does not expressly reference SaaS, its definition of remotely accessed software is broad enough to encompass conventional SaaS subscriptions. Standardized software licensed to multiple customers will largely now be taxable, even if it is accessed solely through a web browser or an Application Programming Interface (API) and remains hosted on the vendor's servers.

IMPORTANT EXCLUSIONS IN THE LEGISLATION 

SB 122, notably, is not intended to tax all digital products or cloud-based services. The legislation expressly excludes:

  • Custom software developed for a single customer
  • Qualifying digital infrastructure
  • Digital books, audio works, audiovisual works, visual works and video game products
  • Certain electronically delivered services that primarily involve human effort

California's custom software exclusion remains in place. However, modifying prewritten software generally does not make the entire subscription exempt. Instead, a modification to prewritten software is treated as custom software only to the extent of the modification. Separately stated charges for qualifying modifications, accordingly, remain an important consideration.

Further, the exclusion for digital infrastructure may be particularly significant for cloud providers; although the distinction between taxable SaaS and exempt infrastructure services remains unclear and will likely require additional guidance from the California Department of Tax and Fee Administration (CDTFA).

To qualify for the human-effort exclusion, services must primarily involve the application of the provider's human effort, and that effort must originate after the customer requests the service. The exemption does not apply merely because customers access software through a web browser, thin-client interface or API.

NEW COMPLIANCE RULE FOR LARGE PURCHASERS

SB 122 also creates a new compliance rule for certain large software transactions. The legislation states that if a retailer's aggregate gross receipts from electronically transferred or remotely accessed digital products sold to a single purchaser exceed $5 million during the current calendar year — or beginning Jan. 1, 2028 during the current or preceding calendar year — the purchaser becomes liable for the use tax on the threshold transaction and subsequent qualifying transactions.

The purchaser will then likely need to obtain a use tax direct payment permit, self-assess the tax and remit it directly to the CDTFA. This provision shifts the reporting obligation, not the tax, from the retailer to the purchaser.

SOURCING RULES

SB 122 establishes new sourcing rules for digital products transferred electronically or accessed remotely. Remote sales are typically sourced to the purchaser's known California address in the seller's records. If multiple California addresses exist, the following hierarchy applies:

  • Billing address
  • Shipping or delivery address
  • Mailing address associated with the payment instrument
  • Mailing address

Qualifying purchasers can also issue a Multiple Points of Use (MPU) exemption certificate, allowing the seller to treat the sale as exempt from tax collection, while the purchaser reports and remits the applicable use tax based on where the software is used. If none of the address rules apply, the sale is generally treated as occurring outside of California.

GHJ Observations: For use tax purposes, a digital product is used where the purchaser exercises the right to use or remotely access the software. Businesses with multistate users should consider whether use tax may be reportable based on where the software is actually used, particularly where the purchaser is responsible for remitting use tax under SB 122's $5 million purchaser reporting rule.

LOOKING AHEAD

SB 122 represents a significant expansion of California's sales and use tax base, with noteworthy implications for SaaS and technology companies. Before the legislation’s Jan. 1, 2027 effective date, businesses should evaluate pricing and contract terms, billing system readiness, customer location and use data, bundled SaaS and service offerings, and potential margin impacts. Companies should also consider whether existing contracts permit sales tax to be passed through to customers or if their systems can properly source and collect tax on multistate transactions.

The impact is not limited to SaaS vendors. Businesses purchasing significant amounts of software should evaluate their own use tax and reporting obligations, particularly when they may become responsible for reporting and remitting tax under the $5 million purchaser rule. Both vendors and purchasers can begin preparing for implementation now while monitoring additional CDTFA guidance.

At GHJ, its State and Local Tax Practice is monitoring the impact of SB 122 on businesses and vendors across the state. Contact the team to learn how this can affect your business.