California’s newly signed Senate Bill 122 will bring meaningful changes for businesses that sell, purchase or use digital software and software-as-a-service products in the state. Beginning January 1, 2027, California will expand its sales and use tax base by treating certain digital products — including prewritten computer software, electronically delivered software and remotely accessed software (“SaaS”) — as tangible personal property for sales and use tax purposes.
The legislation also extends California’s existing limitation on business tax credits and temporarily reduces the first-year annual tax for certain newly formed pass-through entities. Businesses with California customers, users, locations or tax credit positions should begin reviewing how the law may affect their compliance obligations before the January 1, 2027 effective date.
Digital Software and SaaS Will Be Treated as Taxable Tangible Personal Property
One of the most significant changes under SB 122 is the expansion of California’s definition of tangible personal property to include certain digital products and associated copyright or patent interests. Under the law, “digital product” includes prewritten computer software transferred on tangible storage media, transferred electronically or accessed remotely.
That change means California sales and use tax may apply to transactions involving:
- Prewritten computer software transferred on tangible storage media
- Prewritten software transferred electronically
- Remotely accessed software, including software accessed through a digital code, password or similar means when the software resides on the vendor’s server or a third-party server
SB 122 does not treat every digital item the same way. The law excludes certain categories from the definition of digital product, including digital assets, digital audio works, digital audiovisual works, digital books, digital infrastructure, digital video game products and digital visual works. Custom computer software also continues to receive separate treatment under the law.
Sourcing Rules Will Matter for Digital Transactions
For digital products that are transferred electronically or accessed remotely, SB 122 creates sourcing rules that determine where the sale or purchase is considered to occur. For in-person sales at a seller location where the seller is required to hold a seller’s permit, the transaction is sourced to the seller’s California place of business where the in-person sale or purchase occurred.
For such digital transactions (transactions of digital products transferred electronically or accessed remotely) that are not in-person sales, the sale or purchase is determined via destination-based sourcing and is thereby sourced to the purchaser’s known address in California based on records maintained by the seller in good faith. If more than one address is available, the law provides an order of priority that begins with the purchaser’s billing address, followed by shipping or delivery address, payment instrument mailing address and then mailing address.
These sourcing rules make accurate customer address data especially important. Businesses that sell digital software or SaaS products into California should review whether their billing systems, customer records and tax engines are capturing the right information before the effective date.
High-Volume Purchasers May Have Direct Payment Obligations
SB 122 also includes provisions affecting high-volume purchasers of digital products. In certain circumstances, when sales of digital products transferred electronically or accessed remotely exceed $5 million in the aggregate, the purchaser may become responsible for self-assessing and paying use tax directly to the California Department of Tax and Fee Administration. Beginning January 1, 2028, that threshold may be measured using the current or preceding calendar year.
A purchaser that is required to pay use tax directly under these provisions must obtain a use tax direct payment permit. Businesses with significant digital software or SaaS spend should evaluate whether their purchasing volume, vendor relationships and internal tax processes may create additional direct-pay compliance requirements.
California Business Credit Limitation Extended Through 2029
SB 122 also extends California’s $5 million limitation on the use of business tax credits. The limitation, which previously applied for taxable years beginning on or after January 1, 2024 and before January 1, 2027, is extended through taxable years beginning before January 1, 2030.
Beginning in 2030, SB 122 creates a modified business credit limitation equal to the greater of 70% of the tax imposed or $5 million. The limitation applies to both corporate and personal income taxpayers, with certain exceptions and carryover provisions included in the legislation.
Businesses that rely on California tax credits should review their projected credit usage, carryforward positions and cash tax planning in light of the extended limitation.
Temporary First-Year Relief for Certain Pass-Through Entities
SB 122 also provides limited first-year relief for certain newly formed pass-through entities. For taxable years beginning on or after January 1, 2027 and before January 1, 2030, the annual franchise tax for newly formed limited partnerships, limited liability partnerships and limited liability companies is temporarily reduced from $800 to $400 for the entity’s first taxable year.
The legislation states that this change is intended to help reduce costs for first-year California small businesses. While this may provide modest relief for new entities, businesses should still evaluate their broader California filing and compliance obligations before forming or registering an entity in the state.
What Businesses Should Do Before January 1, 2027
Businesses selling or purchasing digital software, SaaS or other digital products connected to California should begin preparing now. Key steps may include:
- Review digital product offerings
Identify whether your products include prewritten software, electronically delivered software or remotely accessed software that may fall within SB 122’s definition of a taxable digital product.
- Evaluate customer and user location data
Confirm whether billing systems, contracts and customer records capture the California address information needed to apply the law’s sourcing rules.
- Assess billing and tax engine setup
Determine whether invoicing, sales tax software and exemption certificate processes will need updates before the January 1, 2027 effective date.
- Analyze use tax exposure
Businesses with significant digital product purchases should consider whether they may have self-assessment or direct payment obligations under the $5 million threshold provisions.
- Revisit California tax credit planning
Taxpayers using California business credits should model the extended limitation through 2029 and the modified limitation beginning in 2030.
Anders Can Help You Prepare for California’s Digital Tax Changes
SB 122 creates new considerations for businesses that sell, purchase or use digital products in California. The changes may affect taxability decisions, customer data requirements, billing processes, use tax reporting and long-term California tax credit planning.
Anders State and Local Tax advisors can help your organization evaluate how SB 122 may apply to your business, identify potential exposure and prepare for the January 1, 2027 effective date. Request a meeting below to discuss your California sales and use tax obligations and next steps.