California is considering a significant expansion of its sales and use tax base to include sales of digital prewritten software, regardless of how the product is delivered. The proposal would apply to software delivered by physical medium, electronic transmission or download, or remote access through the internet, including software as a service (SaaS), where the customer accesses the software hosted by the vendor but does not take possession of it. If enacted, the proposal would have California joining a significant number of other states that already subject software to their sales and use taxes regardless of how it is delivered. It would take effect on January 1, 2027, and could materially affect software vendors, SaaS providers, and businesses that purchase software for use in California.[1]
Where the Proposal Stands
The proposal is not yet law, but it is now reflected in in-print budget trailer bill legislation. The proposal was initially reflected in the governor's 2026-27 May Revision budget package as draft trailer bill language identified as "Taxation of Digital Prewritten Software," and it now appears in revenue trailer bill materials for SB 122 and SB 176. The California legislature adopted a budget bill by the June 15 constitutional deadline, but negotiations with the governor and related budget trailer bill language may continue before the state fiscal year begins on July 1.[2]
Because the proposal is moving through the budget trailer bill process, businesses should continue to monitor further developments. The final statutory language will be important in determining the scope of the tax, including how California treats bundled software and services, implementation fees, customization, support, maintenance, and multi-jurisdictional software licenses.
What Would Change
California currently taxes prewritten software when it is transferred on tangible media, such as a disk, flash drive, or other physical storage device.[3] By contrast, California generally does not tax prewritten software that is downloaded from a server or otherwise transferred electronically, so long as the customer does not receive tangible personal property.[4] Custom software is generally exempt regardless of how it is delivered.[5]
The governor's proposal would largely eliminate that delivery method distinction for prewritten software. Under the proposal, California sales and use tax would apply to retail sales of prewritten software regardless of whether the software is transferred on physical media, electronically downloaded, or accessed remotely. As a result, many software subscriptions and SaaS arrangements that are currently treated as nontaxable in California could become taxable beginning in 2027 if the proposal is enacted in its current form, to the extent they involve access to prewritten software. Custom software would remain exempt.[6]
The proposal is expected to raise significant revenue. The Legislative Analyst's Office reports that the administration estimates that the change would raise about $450 million in General Fund revenue and $560 million in local sales tax revenue in fiscal year 2026-27, when the tax would apply for only half the fiscal year. On a full-year basis, the proposal is projected to raise about $900 million in General Fund revenue and $1.1 billion in local sales tax revenue annually.[7]
Business Considerations
Software vendors and SaaS providers should begin evaluating whether their offerings would be treated as taxable prewritten software, exempt custom software, nontaxable services, or bundled transactions containing both taxable and nontaxable components. This review may require looking beyond product names and focusing on the substance of what customers receive, how contracts describe the offering, how charges are stated on invoices, and whether any customization or professional services are separately priced.[8]
Purchasers of software should also monitor the proposal because it could increase the cost of software used in California. The impact may be especially significant for businesses that purchase enterprise software, cloud-based productivity tools, accounting and finance platforms, human resources systems, customer relationship management tools, data analytics platforms, and other subscription-based products that are currently purchased without California sales tax.
Several practical questions remain unresolved. If the proposal is enacted, in order to implement the expanded tax, California will need to provide guidance on a variety of topics, potentially including how the tax applies to mixed software and service contracts, optional and mandatory maintenance agreements, implementation and training fees, custom modifications to prewritten software, enterprise licenses used by employees in multiple states, sourcing rules and customer location sourcing for remotely accessed software, and any circumstances in which purchasers may be required to self-assess or remit use tax.
For now, the proposal remains pending budget trailer bill legislation rather than an enacted change. However, because the proposed January 1, 2027 effective date would require systems and contract changes before the end of 2026, businesses that sell or purchase software should consider reviewing product classifications, contract language, invoicing systems, customer location data, and California tax collection processes before the end of 2026.
How We Can Help
We are closely monitoring California's budget process and any revised trailer bill language addressing digital prewritten software. Our Transactional Tax team can help businesses evaluate how the proposal may affect their products, contracts, sourcing, billing systems, exemption positions, and California sales and use tax compliance obligations. We can also assist taxpayers in preparing for potential implementation issues if the proposal is enacted.
[1] See Cal. Dep't of Fin., May Revision 2026-27 97 (2026) (proposing, effective January 1, 2027, to apply sales tax to sales of digital prewritten software regardless of delivery method, including remote access through the internet and SaaS); see also Seth Kerstein, The 2026-27 Budget: Sales Tax on Prewritten Software, Cal. Legis. Analyst's Off. (May 16, 2026).
[2] See Cal. Const. art. IV, § 12(c)(3).
[3] See Cal. Code Regs. tit. 18, § 1502(f)(1); see also id. § 1502(b)(13).
[4] See Cal. Code Regs. tit. 18, § 1502(f)(1)(D); see also Cal. Dep't of Tax & Fee Admin., Internet Sales: Nontaxable Sales, Pub. 109 (rev. Apr. 2024) (stating that sales of canned or non-custom software downloaded from a server generally are not subject to tax, but the transaction can become taxable if the seller also provides a backup copy on tangible media).
[5] See Cal. Code Regs. tit. 18, § 1502(f)(2)(A).
[6] Kerstein, supra note 1.
[7] Id.
[8] See Cal. Code Regs. tit. 18, § 1502(f)(1), (g)(1)(B)-(C), (f)(2)(A)-(B), (g). Existing California regulations distinguish among prewritten programs, custom programs, custom modifications, optional maintenance contracts, and consulting or implementation services. Those distinctions may become more important if digital prewritten software becomes taxable.