California SB 122 Says Where Software Is Taxed, Not How to Allocate The Bill

SB 122 takes effect January 1, 2027. Taxability is the easy question. Allocation is the one that could cost you money.

Take a company headquartered in San Francisco with 4,000 global employees, 300 of them in California. It signs a $1.2 million annual enterprise software subscription, billed to the San Francisco office.

Starting January 1, 2027, California taxes all $1.2 million under SB 122, not just the seats that sit in California. At the state rate, that is roughly $87,000. In a high district like Los Angeles County it is closer to $123,000, and at the top combined rate in the state it approaches $135,000.

Now imagine the opposite situation for the same 300 California users. This time, the company’s main office is in Florida, and the bill goes to a Florida address. Because of California’s new billing rule, this sale would count as happening outside California, so the software company would not have to collect any tax on it – but that doesn’t mean that tax isn’t owed. For software used over the internet, the law looks at where the people using it sit, not where the bill goes. And 300 of those people sit in California.

One rule decides whether the seller has to collect tax. Another rule decides whether the buyer still owes tax anyway. SB 122 only changes the first rule, but it doesn’t erase the second one. So if your bill comes from outside California but your workers are inside it, you may need to calculate and pay that tax yourself.

In states like New York or Texas, a company in this spot could file a special form, called a multiple-points-of-use certificate, to split the cost based on how many users sit in each state. California does not offer that option. SB 122 tells you which address counts, but not how to divide the bill.

The hard part used to be determining whether you owed tax. Now, the challenge is figuring out how much, since California has not given companies a formula or any guidance for splitting up a contract that touches many states.

What SB 122 changes

Governor Newsom signed SB 122 into law as part of the state budget. It does not create a new digital tax. Instead, it widens California’s definition of taxable property to include digital products, such as prewritten software, whether shipped on a disc, delivered electronically, or accessed remotely. This broader definition covers most subscription-based products today.

That matters because digital products will get taxed the same way physical goods do, including local city and county taxes on top of the state rate. That is why the tax is not one flat number. It is 7.25 percent plus whatever local taxes apply. Digital sales also will count toward the $500,000 sales threshold that triggers a company’s duty to register in California. A software company in Florida that sells $600,000 to California customers, and has never filed there, would be on the hook next year.

It’s worth noting that some digital products remain exempt: cryptocurrency, digital audio and video, digital books, digital video games, and cloud infrastructure services such as Infrastructure-as-a-Service and Platform-as-a-Service.

Why the sourcing rule is key

To figure out where a sale happened, California checks a list of addresses in order: billing address, then shipping address, then the address tied to the payment method, then any other address on file. Whichever one is found first decides the answer. No California address anywhere on that list, and the sale is sourced outside the state. In-person sales are simpler because they are generally taxed where the seller is.

For physical goods, most local tax in California is based on where the seller sits. Software will now be taxed based on where the buyer sits, a real shift in how local tax money moves. Sellers and buyers also cannot make side deals to shift or refund that local tax.

But this list picks one address; it does not split the bill. A contract billed to a California address (even with users spread across 40 states) can be taxed as if the whole thing happened in California, and there is no official form to divide it. CDTFA, the state tax agency, can approve another method if it fairly reflects actual in-state use, but nobody yet knows what it will accept.

This means that buyers and sellers sit on opposite sides of the same guess. Sellers must decide whether to collect tax on the full contract, knowing the customer may later want most of it refunded. Buyers must decide whether to just pay the bill or pay it while disputing it to preserve a refund claim.

Understanding the custom software exemption

Software built specifically for one customer is still tax-exempt. Software sold or leased to many customers is not, even if it started as a custom build. If a company modifies existing software, only the tweak counts as custom, and only if it is billed as its own line item.

Compare that to a typical enterprise rollout: a heavily configured platform, a six-month setup, custom features, and integration work. Under this law, that is still ordinary software with services attached, not custom software. Companies and the state have argued over this prewritten-versus-custom line for thirty years. Some companies will look to California’s services exemption instead — the rule that treats a transaction as a nontaxable service, rather than a sale of property, when it’s mostly human effort rather than a product being transferred. It won’t help here. SB 122 specifically carves out the right to access software remotely from that exemption, closing off the argument before anyone can make it.

So separately listed implementation charges now matter a lot. If a contract bundles license, setup, and managed services into one line, the whole line is taxable.

Above $5 million, the obligation flips

Once a seller’s sales to one customer top $5 million in a year, the seller stops collecting tax, and the buyer must calculate and pay it directly to the state. For 2027, that $5 million test looks only at the current year. Starting in 2028, it looks at the current or prior year, and starting in 2031 the threshold rises with inflation.

This is the rule most likely to cause an audit problem, because it depends on two companies independently reaching the same conclusion. The seller assumes the buyer is handling it. The buyer assumes the seller is. Neither pays. It is also unclear whether the buyer needs a special permit to pay this tax correctly.

If your California relationship is anywhere near $5 million, get the answer in writing from the other side before January 1, inn a plain email that states who is remitting.

Understanding the costs

For buyers, the math tells a clear story.

This is an example only. Your real number depends on your local district and how much of your software counts as prewritten. But if you are building 2027 budgets this fall and have not added a line for this, you will find it in Q1 instead.

Three provisions are worth planning for:

1. One exempts digital products bought only for use outside California, or for interstate or foreign commerce, if backed by a good-faith certificate.
2. Another exempts the right to copy a digital product for resale to other buyers, which matters for resellers and OEM deals.
3. And a credit is available if another state, or the District of Columbia, already taxed the same digital product.

But be careful: if you buy a digital product outside California and use it in the state within 90 days, the law assumes you bought it for use in California.

Six questions the statute does not answer

CDTFA has two years of emergency authority to write rules for this law. Here is what is still unclear, and what is at stake with each.

1. How to split up a multistate subscription. There is no official form for this yet, and the only fallback, an alternative method, is undefined. This is the biggest dollar risk in the bill.
2. Where the line falls between prewritten and custom software for heavily configured platforms. This decides whether a huge implementation project is taxed at all.
3. How bundled deals combining license, implementation, and managed services get treated. This decides how you should structure your invoices.
4. Where SaaS ends and Platform-as-a-Service begins. PaaS is exempt, SaaS is not, and many products sit right on that line. Classify by the product, not by the vendor. Large cloud providers sell both.
5. Whether technology transfer agreement rules apply. SB 122 pulled copyright and patent rights into taxable property. Under Nortel Networks and Lucent Technologies, companies could exclude the value of intangible property from the taxable price. If that logic carries over here, the taxable amount could shrink a lot. If SB 122 was written to block that, the full invoice is taxed. This is an open question in the bill, and it has barely been discussed.
6. How this interacts with existing exemptions, including the one for manufacturing equipment with embedded software.

Positions taken now may need to change later. Be sure to document why you took each position so that updating it later is a quick memo, not a full redo.

Preparing for January

Start with classification, since everything else depends on it. Map every revenue stream and major software purchase into one of three buckets: taxable prewritten software, exempt custom software, or an excluded category. Write down your reasoning for the close calls.

Then check your data. The sourcing rule depends on good billing addresses. If your records are incomplete or outdated, the whole process breaks at step one and your tax rate will be wrong. A single flat rate will not work either, since combined rates run from 7.25 percent to over 11 percent depending on where the buyer sits.

Then review contracts. Find every agreement that is silent on transaction taxes, every multi-year deal prepaid in 2026 that runs into 2027, and every customer relationship nearing $5 million. Silence in a contract signed before this law existed will not protect anyone, and somebody will end up absorbing the cost.

How Exactera can help

Our Indirect Tax team handles product taxability reviews, nexus studies, voluntary disclosure, audit defense, and strategy, combining senior tax expertise with technology-driven delivery.

If you would like a read on your California software exposure before January 1, reach out at info@exactera.com or visit exactera.com/services/indirect-tax.

Read the chaptered bill text on leginfo.legislature.ca.gov

Provided for general informational purposes and not as tax or legal advice. Statutory references are to the California Revenue and Taxation Code as amended by Chapter 23, Statutes of 2026. Consult the enrolled bill text and pending CDTFA guidance before relying on any position described here.

Appendix: bill reference