California’s 2026–27 budget package has advanced materially since Gov. Gavin Newsom’s May Revision. The operative tax trailer bill, SB/AB 122, would extend California’s sales and use tax to digital prewritten software and Software-as-a-Service (SaaS), effective Jan. 1, 2027, and would revise the state’s business credit limitation rules. The budget bill passed the Assembly on June 15, and SB/AB 122 is expected to proceed to Senate concurrence on June 18 as part of a reported three-party agreement among the Assembly, Senate, and Governor.
Although the updated proposal softens the Governor’s original immediate permanent business credit cap, the core software and SaaS tax remains in the bill. Together, the measures would represent a significant expansion of California’s revenue base, with potentially meaningful procurement, compliance, and income tax planning consequences for businesses operating in California.
Legislative Status
SB/AB 122 is now the principal vehicle for both the software/SaaS sales tax and the alternative business credit cap structure. While further negotiations may continue before final enactment, the current package has been described as a consensus revenue agreement among legislative leaders and the Governor, making significant changes increasingly difficult.
Sales and Use Tax on Digital Software and SaaS
If enacted, SB/AB 122 would impose California’s full state and local sales and use tax — currently 7.25% plus applicable district taxes — on a broad class of digital transactions that have historically been treated as nontaxable, effective Jan. 1, 2027.
The proposal remains technically complex and would provide relatively limited buyer-side allocation tools compared to other states that tax electronically delivered software.
What Would Become Taxable
SB/AB 122 would expand several definitions in the sales and use tax law to reach digital transactions:
- “Sale” and “purchase” would be amended to include “any permanent or temporary transfer of the right…to open, view, access, download, copy, update, possess, store, manipulate, or otherwise use a digital product transferred electronically or accessed remotely.”
- “Digital product” would be defined to include prewritten computer software transferred on tangible media, transferred electronically, or accessed remotely, including SaaS and cloud-accessed software.
- “Tangible personal property” would be amended to include “digital products” and any associated copyright or patent interests.
- A new California Revenue and Taxation Code § 6009.5 clarifies that merely holding a license, without action by the purchaser “to use the digital product to perform a task for which it was designed,” is not a taxable “use.” Instead, a taxable “use” arises only when the purchaser actually exercises the right to use the software for its intended purpose.
In practical terms, most material transfers of rights to use prewritten software — whether by perpetual license, subscription, term license, or remote access — would be treated as taxable.
Equally notable is what the bill would not reach. As drafted, the new tax base would be centered on prewritten software and SaaS. It would not extend to several categories of digital goods that many other taxing states have brought into their sales tax bases, including crypto or other digital assets, digital audiovisual works, digital audio works, digital books, infrastructure-as-a-service, video games, and digital visual works. Custom software would remain exempt, but modifications would be treated as custom software only to the extent of the modification.
How the Tax Would Be Sourced
The trailer bill would source transactions that are not delivered on tangible media to the purchaser’s California address, which would be applied in a fixed priority: (i) billing address; (ii) shipping or delivery address; (iii) mailing address associated with the payment instrument; and (iv) any other mailing address.
The result is that a single California address — most often the billing address — would determine the tax treatment of the entire transaction, regardless of where the digital product is used.
For purchasers whose California address corresponds to where the software is actually used, the proposal is administratively straightforward. For multistate and multinational enterprises, however, the rule, if advanced, may create a structural mismatch that does not account for software purchased and billed centrally but used by the business in other states or abroad.
Allocation Tools: What the Trailer Bill Does and Does Not Provide
The bill does not incorporate a Multiple Points of Use certificate or comparable allocation device of the kind familiar from other taxing states. However, if passed, the bill would implement two primary mechanisms that may operate as partial substitutes in specific fact patterns:
- Large-purchaser self-remittance rule for purchases from a single retailer exceeding $5 million per year. In that circumstance, the retailer would be relieved of liability, and the purchaser would self-remit use tax directly to the California Department of Tax and Fee Administration (CDTFA). This rule would shift remittance responsibility; it would not operate as an exemption from tax. The $5 million threshold would be indexed for inflation beginning in 2031.
- Interstate commerce exemption for digital products purchased solely for use out-of-state, interstate, or in foreign-commerce use. The seller would be relieved of collection if they accept a certificate in good faith. The CDTFA would also be able to authorize an “alternative method” to calculate the in-state use tax that “fairly reflects” the in-state use.
Together, these mechanisms address only a narrow band of fact patterns and would not provide a general mechanism to apportion tax based on multistate use. For transactions that would not meet the large-purchaser self-remittance threshold and would not qualify for the interstate commerce exemption, the bill would effectively source the transaction to the purchaser’s California address, with priority given to the billing address.
Other Notable Features
The trailer bill would also prohibit agreements between purchasers and retailers of digital products that would divert Bradley-Burns local tax and authorize the CDTFA to redistribute any misallocated local revenue.
The bill would grant the CDTFA two-year emergency regulatory authority, signaling that much of the key operational detail — including the contours of the “digital product” definition and the CDTFA’s approach to authorizing “alternative” allocation method under § 6372(d)(3) — may be developed through rulemaking rather than the statute.
The bill is also silent on several recurring software taxability questions, including the line between custom and prewritten software, the treatment of bundled transactions, and the application of Technology Transfer Agreement (TTA) principles to digital licensing. If SB/AB 122 is enacted, these issues may need to be addressed through CDTFA guidance.
If passed, the bill may also limit the application of the TTA provisions, as applied in Nortel Networks Inc. v. Bd. of Equalization and Lucent Techs., Inc. v. Bd. of Equalization, which operate to exclude from “sales price” an “amount charged for intangible personal property transferred with tangible personal property in any technology transfer agreement.” The bill’s attempt to broaden the definition of “tangible personal property” to include digital products, may limit the application of TTAs.
A Parallel Income Tax Proposal: Business Credit Limitations
While the digital product proposal would expand the sales and use tax base, the credit limitation proposal would reduce the offsets available against existing income tax liability. The combined effect for many California taxpayers may be a higher effective state tax cost from two distinct sources — both a new sales tax cost embedded in software and SaaS procurement and a reduced ability to offset income tax liability.
Credit Limitation
SB/AB 122 would replace the Governor’s original proposal for an immediate permanent credit limitation with a phased structure. The bill would extend the existing $5 million limitation on business credit utilization through tax years 2027, 2028, and 2029. Beginning in tax year 2030, business credits would be limited permanently to the greater of $5 million or 70% of the taxpayer’s, or combined reporting group’s, tax liability.
This structure is more taxpayer-favorable than the May Revision’s immediate permanent limitation to the greater of $5 million or 50% of liability, but it would still extend material limitations on credit utilization beyond the current temporary regime. Net operating losses would not be impacted, and the proposal would not appear to alter the 2024 budget deal relating to refundable tax credits.
If enacted, the continued and then permanent cap would increase tax for businesses holding substantial credit balances — particularly those engaged in research and development activities in the state or with significant carryforward credit positions.
Accordingly, taxpayers may wish to revisit their California return filings, including their California apportionment positions, which previously may not have been a material focus when business credits largely offset liability.
Other Budget Tax Items
SB/AB 122 also includes several narrower tax provisions, including a temporary reduction of the annual LP, LLP, and LLC tax from $800 to $400 for the first taxable year during 2027 through 2029, and a 100% tax on payments from the federal Anti-Weaponization Fund or successor funds for 2026 through 2029, with no offsetting deductions or credits.
