California will tax SaaS and software subscriptions starting in 2027

California is expanding its sales tax to cover software sold and used online starting January 1, 2027. Governor Gavin Newsom signed Senate Bill 122 on June 29, 2026, redefining electronically delivered software, Software-as-a-Service platforms, and certain digital products as taxable goods. For software companies, SaaS vendors, and their customers, the change requires rethinking how sales are sourced and taxed across California's regions. This marks a fundamental shift: California, which hosts more software buyers than any other state, previously granted tax-free status to SaaS and downloaded software.

The law affects any business that sells prewritten software electronically or offers remotely accessed SaaS—subscription email tools, project management platforms, customer relationship management systems, and analytics dashboards all become subject to California's 7.25 percent state sales tax, plus any local district taxes that apply. Combined state and local rates range from 7.25 percent to 10.25 percent depending on the customer's location. The state expects the change to generate approximately $900 million in General Fund revenue and $1.1 billion in local sales tax revenue annually when fully implemented. California joins Colorado (also effective January 1, 2027) and approximately 19 other states that now tax software subscriptions, but the scale of California's market makes this shift particularly significant for the software industry.

What becomes taxable under SB 122

Starting January 1, 2027, three categories of software and digital products face California sales tax. Prewritten software delivered electronically or transferred online becomes taxable—including software downloaded as a single file, software distributed through a web-based application, or remotely accessed platforms where users log in to a system hosted by the software provider. This covers many SaaS products: project management tools, customer relationship management systems, communication platforms, and analytics dashboards built on prewritten code all become taxable.

Prewritten software delivered on tangible media, such as a USB drive or external hard drive, also becomes taxable, whether sold online or in a store. Downloaded apps and plugins distributed through application stores or direct download links are taxable.

When software is combined with services or physical products for a single price, the bundle can include both taxable and exempt portions. A vendor offering a SaaS platform bundled with implementation consulting must defensibly split the invoice between the taxable software component and the exempt service component.

Custom software—code written specifically for a single customer's needs—remains exempt. General-purpose software that could be sold to multiple customers counts as prewritten and becomes taxable; bespoke development work does not. This distinction is critical: a company selling an off-the-shelf budgeting tool faces tax; a company contracted to build a custom financial system for one corporation does not. The boundary becomes blurry when vendors offer custom modifications to prewritten software, a category where regulatory guidance will likely emerge in the coming months.

What remains exempt

Not all digital goods face the new tax. Cloud infrastructure services remain untaxed. If a customer uses a cloud provider to deploy its own applications and software, the underlying infrastructure—servers, storage, and computing power—is not subject to sales tax. The distinction matters: a company selling access to cloud servers for users to run their own software is exempt; a company selling its own SaaS platform running on cloud infrastructure is taxable.

Video streaming services continue to avoid tax. These services remain exempt whether customers subscribe or watch ad-supported content. The same applies to music streaming platforms, audiovisual works, and audio podcasts delivered online. Electronically delivered books, e-books, and textbooks remain exempt. Video-on-demand services and online courses remain tax-free.

Services that rely primarily on human effort initiated after a customer engages also stay exempt. Consulting, custom design work, implementation services, training, and personal services delivered online do not face the new tax. Digital assets including cryptocurrencies, NFTs, and other digital assets on distributed ledgers are excluded from taxation.

How California determines which local tax applies

California imposes a statewide 7.25 percent sales tax, but most jurisdictions add local district taxes on top, creating rates that vary from 7.25 percent in areas with no local tax to 10.25 percent in high-tax jurisdictions. A software company selling to customers across California must know which rate applies to each customer. SB 122 establishes a strict hierarchy for determining the customer's tax location.

Sellers must use the customer's billing address first. If that is unavailable, they use the shipping or delivery address. If neither exists—common with SaaS and remote-access software where no physical delivery occurs—the system shifts to the address associated with the payment instrument, such as the address on file with a credit card or bank account. If none of those work, the seller uses the customer's mailing address on file. Unlike tax sourcing for physical goods, where delivery location governs, software sourcing is tied to customer identity and location data.

This sourcing rule presents practical challenges for software companies accustomed to simple transaction-based systems. Multi-user software licenses pose particular complications. A software license with users across multiple California cities with different tax rates may need to allocate portions of the sale to different jurisdictions, depending on where each user is located or where the contract is managed. Companies should prepare to update billing and sourcing systems to capture and track customer location data consistently across all revenue transactions. Some vendors may discover that their current systems cannot reliably determine where each customer or user is located.

The $5 million purchaser threshold and nexus rules

SB 122 includes an unusual provision that shifts tax responsibility for very large customers. When a single customer purchases more than $5 million in digital products from a single retailer in a year, the purchaser—not the seller—becomes responsible for calculating and remitting California use tax. This threshold operates by purchase volume, not by seller revenue. A company might have $100 million in total California sales but never trigger the threshold if sales are distributed among many small customers. Conversely, a software vendor serving only a few enterprise customers might hit the threshold if even one of them spends more than $5 million annually.

Large corporate purchasers should expect that sellers will stop collecting sales tax on their orders and will instead note that the purchaser is responsible for self-assessing use tax. The purchaser then calculates which California jurisdictions the usage applies to and remits tax directly to the state. The change relieves smaller vendors from managing compliance on extremely large contracts but transfers the administrative burden to big buyers and their tax departments.

Out-of-state sellers should also note California's nexus threshold: the state requires sellers to register and collect tax only if their California sales exceed $500,000 in a year. This threshold is higher than most other states' $100,000 nexus requirement, offering partial protection to small vendors operating in California. Sellers below this threshold are not required to register with the state, though they may voluntarily do so. However, purchases by California customers remain subject to tax regardless of whether the seller registers, and customers may owe use tax directly to the state.

How companies should prepare

Software companies, SaaS vendors, and anyone selling digital products into California should begin preparing immediately. The January 1, 2027 deadline is less than three months away. First, conduct a comprehensive product review and categorize each product, subscription, or bundled offering to determine whether it is taxable prewritten software, a tax-exempt cloud infrastructure service, or something exempt for another reason. Document the reasoning for each classification; audits may later question these judgments, and clear documentation strengthens a company's defensibility.

Update billing and sourcing systems to ensure customer records consistently capture billing address, shipping address, and payment method address. Configure tax calculation software to apply the correct California rate based on each customer's location. Tax rate ranges from 7.25 percent to 10.25 percent depending on where the customer is located, and errors can compound across thousands of transactions. Test the updated system against sample transactions in different California jurisdictions to verify accuracy before the effective date.

Review customer contracts and license agreements. Many existing contracts specify where tax applies or who bears the cost. Service level agreements, volume discounts, and pricing schedules may need amendment. Large customers approaching or exceeding the $5 million threshold should receive explicit notice in writing that tax responsibility will shift to them starting January 1, 2027. Some vendors may need to negotiate contract amendments to clarify that digital product purchases are now subject to California sales tax and that pricing may change.

Separate invoice line items where possible. When software bundles with services or physical goods, itemizing each component on the invoice helps maintain the distinction between taxable and exempt portions and strengthens documentation if the state audits the sale. Clearly label SaaS subscriptions, support services, implementation fees, and training as separate line items with their respective tax treatment.

Determine whether you meet California's $500,000 sales threshold. If you do, you must register for a California seller's permit from the California Department of Tax and Fee Administration. Registration triggers ongoing compliance obligations. If you fall below the threshold, you are not required to register, but your customers may still owe use tax directly to the state.

Finally, monitor California Department of Tax and Fee Administration guidance throughout the remainder of 2026 and into early 2027. The department is still drafting detailed regulatory language to clarify edge cases, bundling rules, multistate allocation, and the treatment of custom modifications to prewritten software. Regulations may be released as late as December 2026, giving businesses only weeks to implement final changes before the law takes effect.

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