California Enacts SB 122 – Sales Tax Expansion to Digital Products

On June 29, 2026, Governor Gavin Newsom signed Senate Bill 122 (SB 122), the budget trailer bill for the 2026–27 fiscal year, expanding California’s sales and use tax base to include certain digital software transactions, effective January 1, 2027. Under the new legislation, California’s 7.25% statewide sales and use tax, plus any applicable local district taxes, will apply to digital prewritten software and remotely accessed software, including software-as-a-service (SaaS). SB 122 was passed by the Legislature and presented to the governor on June 18, 2026, and, as a budget-related measure, takes effect immediately, with the software provisions operative for transactions occurring on or after January 1, 2027.

Expansion of Sales Tax to Digital Software Transactions

This represents a significant shift from California’s historical treatment, under which electronically delivered or remotely accessed software was generally not subject to sales tax if no tangible personal property was transferred. Under prior law, California’s sales and use tax treatment of software was determined by the manner of delivery. Under the California Department of Tax and Fee Administration’s Regulation 1502, Computers, Programs, and Data Processing, prewritten (or “canned”) software transferred on tangible storage media was generally subject to sales and use tax. In contrast, prewritten software delivered electronically or accessed remotely, such as Software-as-a-Service (SaaS), was generally not subject to sales and use tax because no tangible personal property was transferred. Custom software was generally treated as a nontaxable service regardless of the method of delivery.

What Digital Products Are Affected?

SB 122 amends the definition of “tangible personal property” to include “digital product” and any copyright or patent interests associated with it. It also defines a “digital product” as prewritten computer software transferred on tangible storage media, transferred electronically or accessed remotely. As a result, prewritten software becomes taxable regardless of the method of delivery, whether transferred on tangible media, downloaded or accessed remotely as SaaS.

Although additional administrative guidance is expected, the legislation appears to be more targeted than some other states’ digital tax regimes. The scope of the tax law change is focused primarily on:

The legislation does not appear to broadly tax all digital products. Certain categories, such as custom software, digital books, music, movies, video games, cryptocurrency and other digital assets, appear to remain outside the scope of the new tax.

Sourcing and Compliance Framework

SB 122 establishes a customer-based sourcing regime for digital transactions. For sales not made in person, the transaction is sourced to the purchaser’s California address using a statutory hierarchy, beginning with the billing address and cascading to other available customer data. If no California address is identified, the transaction is treated as occurring outside the state. The sourcing provisions are complex and may differ depending on whether software is electronically transferred or remotely accessed. Additional administrative guidance is expected in this area.

For certain high-volume purchasers of electronically delivered or remotely accessed software, the legislation may shift use tax reporting responsibility from the retailer to the purchaser. This shift will require both sellers and purchasers to reassess processes, particularly for business-to-business transactions. Businesses should closely review these provisions to assess the applicability requirements.

Key Limitations and Exemptions

Although the bill expands the tax base, it includes several targeted limitations. Digital products purchased solely for use outside California or in interstate or foreign commerce may be exempt, placing increased importance on documenting use and user location.

The law also provides an exemption for certain electronically delivered services where the value is primarily derived from human effort performed after a customer request. However, access to software in a cloud environment does not, by itself, qualify for this exemption, limiting its applicability to traditional service models.

At this time, there is no indication that sales of specific software will be broadly exempt unless a transaction qualifies for a specific exemption, such as resale, exempt-entity status or another statutory exclusion.

Corporate Tax Provisions and Broader Changes

In addition to expanding the sales tax base, SB 122 extends the $5 million limitation on business tax credits through taxable years beginning before January 1, 2030, and thereafter modifies the limitation to the greater of 70% of tax or $5 million. The legislation continues the elective regime that allows taxpayers to convert certain credits into refundable amounts over time.

For taxable years 2027 through 2029, the bill temporarily reduces the minimum tax for LLCs, LPs and LLPs from $800 to $400 for the first taxable year, providing limited relief for new entities.

Notably, the legislation also includes a narrow provision imposing a 100% tax on certain settlement payments related to a specified federal fund for tax years 2026 through 2029.

Taxpayer Considerations

Because the legislation is newly enacted and certain provisions remain unclear, additional guidance from the California Department of Tax and Fee Administration is expected. Significant tax base expansions of this nature may also be subject to legal or administrative challenges, particularly where questions arise regarding statutory authority, sourcing, the characterization of software-related services, bundled transactions or the mechanics of self-remittance.

Businesses that buy or sell software in California should begin identifying which of their offerings and purchases are prewritten versus custom and assess how the new tax would affect pricing, contracts and systems ahead of the January 1, 2027, effective date. If you have questions about California’s taxation of SaaS and digitally delivered software, please reach out to a member of Withum’s SALT Team.