California’s Proposed SaaS Tax Key Implications for Software and Technology Companies

Introduction

On May 14, 2026, Governor Gavin Newsom proposed extending California’s sales and use tax to all retail sales of prewritten software, regardless of the delivery method. Under this proposal, digitally downloaded software and software accessed remotely as a service (SaaS) would become subject to the state’s base sales tax rate of 7.25%, plus applicable local district taxes, effective January 1, 2027. The proposal requires approval by the California Legislature as part of the state budget process.

Under current law, California generally taxes prewritten software only when delivered on tangible media, while electronically delivered software and SaaS remain exempt because no tangible property is transferred. Custom software and other electronically delivered digital goods, including e-books, audio, and video files, also remain exempt. Governor Newsom characterized the current framework as outdated because it treats economically similar transactions differently based solely on the method of delivery.

Key Features of the Proposal

The Governor’s proposal would extend the state’s sales tax to all sales of prewritten software broadly, irrespective of how the software is delivered to the end user.

1. Scope
   The tax would apply to prewritten software delivered on tangible media (already taxable), downloaded electronically, and accessed remotely via the internet (SaaS). Major SaaS providers directly affected include Microsoft, Salesforce, Adobe, Oracle, Workday, Atlassian, and Zscaler.
2. Exclusions
   Custom software would remain exempt. Streaming entertainment services (audio and video) are not included in the initial proposal, though the Legislature may revisit this exclusion separately. AI token-based API access (the consumption model used by OpenAI, Anthropic, Google, and comparable providers) is not expected to be covered, though the final statutory language has not been drafted. Further, the proposal addresses only prewritten software, leaving other digital products (text, audio, video files) untaxed, even though many of these products have close analogs that are already subject to sales tax.
3. Tax Rate
   The applicable rate is the combined state and local rate. The statewide base rate is 7.25%, with combined rates reaching as high as 10.75% in certain jurisdictions depending on voter-approved district taxes.
4. Business-to-Business Predominance
   The Governor’s office estimates that 75% of newly taxable transactions would be business-to-business sales.

Practical Considerations for Affected Businesses

Governor Newsom noted that 35 states tax digital prewritten software and 24 tax SaaS in some form. Because California currently does not tax SaaS, the proposal would mark a significant policy shift. If enacted, affected businesses would have approximately six months to prepare.

1. Contract Review
   Businesses should review agreements to determine if tax pass-through provisions are present or if renegotiation is necessary
2. Nexus Implications
   Out-of-state vendors exceeding California’s $500,000 economic nexus threshold could trigger sales tax obligations if prewritten software becomes taxable, even where their products are currently treated as intangible.
3. Custom vs. Pre Written Classification
   The distinction is critical between custom and prewritten software since custom software remains exempt. Evaluate whether current software offerings involve substantial customization that classify as custom software under CDTFA Regulation 1502.
4. Tax Compliance Systems
   Companies selling digital software into California should prepare for taxes on prewritten software and SaaS, while custom software and AI token-based APIs remain exempt. 
5. AI Services
   While AI token-based API access is not expected to be covered, the boundary between taxable SaaS and exempt AI services remains uncertain, creating a potential pricing advantage for AI-native tooling over traditional enterprise SaaS.
6. Bundled Transactions
   Businesses that bundle software with tangible personal property or other services should assess whether their transactions may be partially or fully taxable under existing bundling rules and the impact of the same on nexus considerations.

Implementation Timeline

California Legislature must pass a budget by June 15, 2026. If the SaaS tax is included, the change would take effect on January 1, 2027. However, the proposal could still be modified or removed during the legislative process. We will monitor the budget proceedings closely, particularly for any amendments that may introduce business-use exemptions, reduced rates, phase-in periods, or expanded scope to cover additional digital products beyond software.

Scale’s Communications & Technology Team

Our Communications & Technology team advises companies at the intersection of innovation and regulation. We work with telecommunications providers, infrastructure companies, and technology platforms to navigate complex federal and state frameworks, execute strategic transactions, and manage day-to-day regulatory demands.