California Moves One Step Closer to Taxing SaaS: What Businesses Need to Know

For years, California has been one of the few major states where Software as a Service (SaaS) has generally not been subject to sales tax. That could soon change.

The California Legislature has approved SB 122, a bill that would significantly expand the state's definition of tangible personal property to include many digital products, including downloaded software and remotely accessed prewritten software (SaaS). However, the bill has not yet been enacted. It still requires the Governor's signature before becoming law.

If signed, these changes would become effective January 1, 2027, which would impact thousands of software companies doing business in California.

Here's what businesses should know and what questions still remain.

What's Changing?

Today, California generally taxes software delivered on physical media but not prewritten software delivered electronically or accessed remotely as SaaS.

This bill would dramatically change that by expanding the definition of tangible personal property (TPP) to include certain digital products beginning January 1, 2027. Specifically, the bill defines a digital product as prewritten computer software transferred on tangible storage media, transferred electronically, or accessed remotely.

If enacted, this means both downloaded software and SaaS would generally become subject to California sales tax.

How Does the Bill Define SaaS?

One of the main aspects of the legislation is that it specifically addresses software accessed remotely.

The bill defines "accessed remotely" as prewritten computer software residing on the vendor's server (or a third-party server) that customers access using a password, digital code, etc.

In other words, the legislation isn't simply taxing downloaded software, it also encompasses traditional cloud-based SaaS offerings that many businesses rely on every day.

Downloaded Software Would Also Become Taxable

The proposed legislation would also eliminate much of the historical distinction between software delivered electronically and software delivered on physical media.

If enacted, businesses selling electronically downloaded prewritten software into California would generally be required to collect and remit California sales tax beginning January 1, 2027.

Not Every Digital Product Is Included

Although many headlines have focused on SaaS, the bill is broader than that. At the same time, it specifically excludes several types of digital products from the new definition, including:

• Digital books
• Digital audio works
• Digital audiovisual works
• Digital video game products
• Digital visual works
• Digital assets
• Certain digital infrastructure services

The legislation also continues to distinguish custom software from prewritten software, meaning not every software transaction will necessarily be taxable.

What About Economic Nexus?

California's economic nexus threshold currently requires remote sellers with more than $500,000 in sales of tangible personal property into the state to register and collect sales tax. Because SaaS has generally not been considered tangible personal property, many SaaS companies have not counted those revenues toward the threshold.

If SB 122 is enacted, that changes. Beginning January 1, 2027, revenues from taxable SaaS and downloaded software would become sales of tangible personal property. As a result, those sales could count toward California's $500,000 economic nexus threshold going forward.

But businesses would not be expected to retroactively count historical SaaS revenue toward economic nexus.

Other Services Could Also Be Affected

The bill also addresses services associated with software.

Charges for maintenance, installation, and configuration related to downloaded software or SaaS would generally follow the same tax treatment that currently applies to software delivered via tangible media. This means businesses may need to review not only their software subscriptions, but also the professional services bundled with them.

Questions We're Still Waiting to Have Answered

Although the legislation establishes the statutory framework, many questions still remain.

The California Department of Tax and Fee Administration (CDTFA) will likely issue additional guidance before the effective date to address issues such as:

• How bundled SaaS offerings will be taxed
• Sourcing rules for businesses with users in multiple states
• Treatment of enterprise licenses with multiple users
• Documentation requirements for exempt transactions
• Registration and implementation timelines
• Additional clarification around excluded digital infrastructure services

Until that guidance is released, businesses should avoid making assumptions about how every transaction will be treated.

What Businesses Should Do Now

Even though the bill has not yet been enacted, now is the time to begin evaluating its potential impact.

Companies should consider:

• Reviewing whether their products fall within the bill's definition of a taxable digital product.
• Determining whether California sales could create economic nexus beginning in 2027.
• Assessing whether billing systems, tax engines, and ERP platforms are prepared to tax SaaS and downloaded software.

Preparing now will make implementation significantly easier if the legislation is signed into law.

Final Thoughts

If enacted, SB 122 would represent one of the most significant changes to California's sales tax laws in decades. By expanding the definition of tangible personal property to include many digital products, including SaaS and downloaded software, the legislation could create new collection and compliance obligations for software companies doing business in the state.

While the bill is not yet law, businesses should begin evaluating how these proposed changes could affect them. Understanding your potential exposure today can help avoid last-minute compliance challenges if the bill is ultimately enacted.