If California was the state your US Sales Tax compliance team never had to think about, that changes in six months.
Governor Gavin Newsom has signed Senate Bill 122 into law as part of California’s 2026-2027 budget. From 1 January 2027, sales and use tax will apply to digital prewritten software, including SaaS subscriptions, regardless of how the software is delivered. Downloaded, licensed, or accessed remotely: if it is prewritten software and the customer has a California address, it is now taxable.
California is not a small market. This is one of the most significant US Sales Tax changes in years, and the window to prepare is shorter than most finance teams realise.
The bill imposes sales and use tax on retail sales of digital prewritten software, including SaaS, regardless of how it is delivered: physical media, electronic download, or remote access through a browser, thin client, or program interface.
The key distinction is between prewritten and custom software. Custom software, meaning software prepared to the special order of a single customer, remains exempt. Where a seller modifies prewritten software, only the modification qualifies as custom, and only if the charge for that modification is separately stated on the invoice. A bundled price will not protect the custom element from tax.
Services related to SaaS also remain exempt where they primarily involve the application of human effort that originates after the customer requests the service. That exemption does not reach the SaaS product itself.
The following are expressly excluded from the new tax and remain outside its scope:
One area that remains unresolved is platform as a service (PaaS). The bill leaves its treatment to the CDTFA to determine through regulation, and until that guidance arrives, businesses operating in this space are working without a clear answer. If your operations touch PaaS in any way, this is one to watch closely.
Sales of digital prewritten software are sourced to the purchaser’s known California address, applied through a priority order: billing address first, then shipping or delivery address, then the address tied to the payment instrument, then mailing address. If the seller holds no California address for the customer, the sale is sourced outside the state.
A digital product purchased outside California and used in the state within 90 days is presumed to have been purchased for use in California.
There is also a $5 million threshold that changes who is responsible for the tax. Where a seller’s gross receipts from remotely accessed or electronically delivered digital products to a specific buyer exceed $5 million in a calendar year, liability shifts. Above that threshold, the buyer becomes responsible for self-assessing and remitting use tax directly to the CDTFA. The seller is relieved of the collection obligation for that buyer once the threshold is crossed.
At the state level, the rate is 7.25 percent. Once local jurisdiction rates are applied, the effective rate rises above 10 percent in many areas of California.
For businesses with significant software spend billed to California addresses, the cost impact is material and the way it lands on your P&L depends on the specifics of your contracts, your supplier relationships, and how your billing systems are currently configured. The numbers look different for every business.
The change hits in two directions and both need to be addressed.
The Tax you Charge: If you sell SaaS or prewritten software and you have customers with California billing addresses, you now have a collection obligation. Before that obligation takes effect, you first need to be tracking which of your customers have California billing addresses and what you are invoicing them, so you know exactly what is in scope when the rule starts. From 1 January 2027, you need to be charging sales tax on those invoices unless a specific exemption applies. Anything you miss becomes your liability, plus interest and penalties.
Practically, that means reviewing your customer base, your billing configurations, and your tax engine setup before the deadline. How complex that process is depends on the shape of your business and some businesses will find it significantly more involved than they expect.
The tax you pay: If your business buys software subscriptions billed to a California address, those invoices will carry sales tax from January. Adobe, Slack, Zoom, Microsoft, any prewritten software contract billed to a California address is in scope. Where a vendor does not charge the tax, the obligation does not disappear. It shifts to you as use tax, payable directly to the CDTFA.
How that lands on your accounts payable process and your 2027 operating budget depends on your software stack and your supplier relationships. For some businesses the impact will be manageable. For others it will be significant. The difference usually comes down to how early they assessed it.
One of the most important things to understand about SB 122 is that the bill leaves significant operational detail to the CDTFA to resolve through regulation. The CDTFA has emergency regulatory authority and is expected to issue guidance on a number of open questions, including the treatment of PaaS, multistate subscriptions, and how allocation should work for businesses using software across multiple states.
Unlike New York and Texas, which provide multipoint use frameworks allowing purchasers to allocate a subscription price based on where use occurs across states, SB 122 includes no comparable allocation mechanism. Until the CDTFA issues regulatory guidance, sellers and multistate buyers are left without statutory direction on how to apportion the California-taxable portion of a multistate licence or subscription.
What that means in practice for your business depends on where your customers are based, how your contracts are structured, and how your systems currently handle multistate obligations. It is the kind of question that looks straightforward on the surface and turns out to be considerably more involved once you get into the detail.
This is not a reason to wait. It is a reason to stay close to the CDTFA’s regulatory activity over the coming months and build flexibility into your implementation so that you can adjust as guidance emerges. Businesses that start late will have less room to course-correct.
With six months until the operative date, the preparation window is real but not unlimited. Here is where to focus:
Adjust your operating expenditure model: Re-plan software spend at the new tax-adjusted cost so that 2027 budgets reflect what your software contracts will actually cost. A tool that costs $X today will cost more from January if it is billed to a California address. That delta needs to be in your numbers now, not as a surprise variance in Q1 2027.
Get your systems ready: The new sourcing rules and taxability determinations land on top of the nexus thresholds and rates your US Sales Tax compliance process already manages. Whether your current setup can handle the change cleanly, or whether it needs work, is something most businesses do not know until they look closely. Setup takes time. Starting in December is starting late.
Model the $5 million threshold: If your business has large software relationships with California-based vendors, assess whether any of them are approaching or already above the $5 million threshold that shifts liability to the buyer. Where that threshold applies, your team needs a process for self-assessing and remitting use tax directly to the CDTFA. Whether that process exists, and whether it is fit for purpose, is worth confirming now rather than discovering in January.
1. Does SB 122 apply to custom software?
No. Custom software prepared to the special order of a single customer remains exempt. Where prewritten software is modified, only the modification qualifies as custom, and only if the charge for that modification is separately stated. A bundled price will not protect the custom element from tax.
2. What happens if a vendor does not charge California sales tax on a SaaS invoice?
The obligation does not disappear. Where a vendor does not collect sales tax on a taxable supply to a California address, the buyer becomes liable for use tax and must self-assess and remit it directly to the CDTFA. Assuming the invoice is VAT-free and no obligation exists is a compliance error.
3. Does SB 122 affect businesses based outside California?
Yes. The tax attaches to the customer’s California address, not the seller’s location. A business based entirely outside California that sells SaaS to customers with California billing addresses has a collection obligation from 1 January 2027, once it has nexus in California, and meeting that obligation depends on already tracking which customers carry a California address well before the deadline arrives. Similarly, a business based outside California that buys software billed to a California address will see sales tax added to those invoices from January.
4. What is the $5 million threshold and how does it work?
Where a seller’s gross receipts from remotely accessed or electronically delivered digital products to a specific buyer exceed $5 million in a calendar year, the seller is relieved of the obligation to collect tax from that buyer. Above the threshold, the buyer must self-assess and remit use tax directly to the CDTFA. From 2028, the threshold is assessed against either the current or preceding calendar year.
5. When will the CDTFA issue implementation guidance?
The CDTFA has emergency regulatory authority and is expected to issue guidance on open questions including PaaS treatment and multistate allocation. No formal timeline has been published.
What that guidance looks like, and how it affects your specific obligations, will depend on the detail of what the CDTFA publishes. Businesses that have already mapped their exposure will be in a much better position to act quickly when that guidance arrives.
SB 122 creates new obligations on both sides of the P&L for any business buying or selling prewritten software into California.
How those obligations land on your business specifically, and what needs to change before January, depends on factors that look different for every organisation. The businesses that find out now will have more options than the ones that leave it late.
VAT IT supports businesses in assessing and managing their US Sales Tax compliance position, from nexus reviews and threshold monitoring through to registration, filing, and system configuration across all states.
Get in touch with our team to find out where your business stands ahead of the January 2027 deadline.
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