California is Taxing the Cloud: What Businesses Need to Know
Beginning January 1, 2027, California will expand its sales and use tax rules to cover certain digital products, primarily prewritten computer software, that are downloaded, electronically delivered, or accessed remotely.
Senate Bill 122 represents a significant change for businesses that purchase software subscriptions, cloud-based applications, and other technology services. Businesses should begin reviewing their existing arrangements before the new rules take effect.
What May Be Subject to Tax
Under the new law, sales or use tax may apply when a customer receives the right to access, download, copy, update, store, manipulate, or otherwise use prewritten computer software.
Potentially taxable products may include:
- Off-the-shelf or prewritten software
- Software subscriptions
- Software as a Service, commonly referred to as SaaS
- Many cloud-based business applications
- Licenses providing access to software or digital tools
- Software delivered electronically or on physical storage media
Examples may include accounting and tax software, document-management programs, video-conferencing software, and other subscription-based business applications.
The tax treatment will depend on the product’s functionality, the terms of the agreement, how the product is delivered, and whether an exclusion or exemption applies.
Payments for subscriptions, renewals, licenses, or continued access made on or after January 1, 2027, may also be affected even when the underlying agreement was entered into before that date. Businesses should review existing contracts and monitor additional guidance regarding transition and renewal arrangements.
What May Be Excluded or Exempt
SB 122 provides exclusions and exemptions for several categories of digital products, including:
- Digital audio works
- Digital audiovisual works
- Digital books
- Digital video games
- Digital visual works
- Certain digital assets
- Qualifying digital infrastructure
Qualifying digital infrastructure generally includes cloud infrastructure that allows a customer to create, deploy, scale, or run the customer’s own software. The distinction between excluded digital infrastructure and taxable access to a provider’s prewritten software may require careful review.
Custom computer software also generally remains exempt. When prewritten software is modified for a customer, the separately stated portion of the charge attributable to qualifying customization services may be excluded.
Professional and Human-Effort Services
Services that primarily involve human effort may remain exempt when the work is performed after the customer requests the service.
For example, a professional service does not become taxable merely because the final report, analysis, or document is delivered electronically. However, a charge for access to a provider’s software platform may not qualify for the same treatment.
Businesses purchasing bundled arrangements that include both software access and professional services should review how the charges are described and stated in the agreement.
Other Potential Exemptions
Depending on the circumstances, exemptions may also apply to:
- Digital products purchased for resale
- Products used solely outside California
- Certain interstate or foreign commerce transactions
Determining where a digital product is used may be more complicated when employees work remotely, operate in multiple states, or access the same software from several business locations.
What Businesses Should Do Now
Businesses should consider taking the following steps before January 1, 2027:
- Inventory software subscriptions, licenses, and cloud-service agreements
- Identify which products provide access to prewritten software
- Review contracts for separately stated software, implementation, customization, and professional service charges
- Determine where employees and other authorized users access the products
- Confirm whether vendors intend to collect California sales tax
- Retain documentation supporting any claimed exclusion or exemption
Additional guidance from the California Department of Tax and Fee Administration is expected, particularly regarding sourcing, multistate use, existing agreements, and the distinction between taxable SaaS and excluded digital infrastructure.
SB 122 contains detailed definitions and requirements, and the tax treatment of a particular arrangement will depend on the applicable facts and contract terms. Please contact DBMCPA to discuss how the new rules may affect your business and its current software, licensing, and subscription arrangements.
