California Is Expanding Sales Tax to Digital Products and Software

Recently, California Governor Gavin Newsom signed SB 122 into law, broadening the definition of tangible personal property to include certain digital products. Starting January 1, 2027, prewritten computer software will be subject to California sales and use tax when it is:

• Delivered on tangible storage media
• Transferred electronically
• Accessed remotely, which includes Software as a Service

Understanding the Expanded Tax Base

SB 122 expands the California sales and use tax base to include certain digital products, including prewritten computer software. Historically, California only imposed sales tax on prewritten software delivered on tangible media, while electronically downloaded software and SaaS remained outside the tax base.

However, as of January 1, 2027, SB 122 effectively taxes software as tangible personal property regardless of delivery method.

While this legislation significantly expands the tax base, it specifically excludes certain digital products, including digital books, video games, digital audio, visual, or audiovisual works, digital infrastructure, and more. Custom software designed specifically for a customer also remains exempt.

Sourcing Considerations

SB 122 further addresses new sourcing rules for taxable digital products and uses a purchaser-address hierarchy with the following order of priority:

• Purchaser’s billing address
• Purchaser’s shipping or delivery address
• The mailing address associated with the purchaser’s payment instrument
• Purchaser’s mailing address

The purchaser-address hierarchy may be a significant change for businesses that are used to sourcing sales based on shipping or delivery location. Businesses that license software to customers with users located across the United States may face additional challenges in determining how software usage should be allocated for California sales tax purposes.

Developments to Watch/Emerging Considerations

The California Department of Tax and Fee Administration (CDTFA) held an Interested Parties Meeting to discuss draft regulations implementing SB 122. Stakeholders expressed concerns about the sourcing hierarchy, including how the hierarchy will work when sellers have multiple addresses for a customer, how businesses should reconcile California’s sourcing rules with rules used by other states, and more.

Stakeholders have also expressed concerns about how the expanding tax base affects existing contracts, practical application of multiple points of use certificates, and where the line is drawn between taxable software and excluded digital products.

Final regulations are anticipated before January 1, 2027, when SB 122 goes into effect.

What do I need to do?

SB 122 fundamentally changes how California taxes software. Companies selling or licensing software into California should not wait for final regulations to begin evaluating their product mix, customer addresses, and contract terms.

Next steps include:

• Reviewing your software and digital product offerings to determine if they will now be subject to sales tax under SB 122.
• Assessing customer locations and sourcing methodology to meet the purchaser-address sourcing requirements.
• Reviewing contracts and software license agreements to determine how software usage should be allocated.
• Documenting these findings and maintaining clear records to support tax positions in the event of a review or audit.

Our State and Local Tax team can help you ensure compliance and understand the implications of ever-changing state tax laws.