Tax Insight

California budget proposal would tax digital prewritten software, permanently limit business tax credits

Insight
5 minute read
May 29, 2026

What happened?

Governor Gavin Newsom’s May Revision to California’s 2026-2027 budget proposes to apply sales and use tax to transactions involving digital products transferred on tangible media, transferred electronically, or accessed remotely, including prewritten computer software and software as a service (SaaS), effective January 1, 2027. Under the proposal, sales and use tax would apply regardless of how the software is delivered or accessed.

The proposal also includes a permanent income and franchise tax credit utilization limitation of the greater of 50% of the combined tax liability or $5 million for tax years beginning on or after January 1, 2027. This permanent limitation would come on the heels of the temporary credit limitation ($5 million for each tax year beginning on or after January 1, 2024 and before January 1, 2027) and NOL suspension (for tax years beginning on or after January 1, 2024 and before January 1, 2027) under current law.

Why is it relevant?

The proposal would permanently limit business tax credit utilization and significantly expand the sales tax base to include electronically delivered software and remotely accessed software. Vendors and purchasers of SaaS would face new sales tax collection, remittance, and cost considerations if the proposal is enacted under the statutory framework. The proposal introduces sourcing hierarchies and, under certain circumstances, shifts the liability for tax payment from the retailer to the purchaser for large-scale transactions. Taken together, the credit limitation and sales and use tax base expansion is projected to generate state and local revenues of approximately $1.3 billion for 2026-2027, rising to $2.9 billion by 2029-2030.

Actions to consider

California’s budget must be adopted by the legislature no later than midnight on June 15. Details may still be subject to change for a period of time after that deadline. Businesses should model the potential impact of the permanent credit limitation, NOL suspension sunset, prior elections, and potential future elections that could enhance credit benefits.

Purchasers and sellers of software in California should consider the following steps in consideration of the proposed January 1, 2027 effective date:

Identify offerings that constitute digital products, including prewritten computer software, SaaS, and other electronically transmitted solutions, and assess how those offerings are currently treated for sales tax purposes.
Evaluate systems and billing processes to determine whether they can distinguish taxable software transactions (across all delivery methods) and apply sales tax appropriately.
Evaluate accrual processes to determine whether they can identify taxable software purchases and self-assess use tax where needed. Consider whether any exemptions are available for interstate or other use outside California.
Consider the potential impact of the tax on pricing, contract terms, and planning for transactions occurring on or after January 1, 2027.
Monitor the budget process, any implementing legislation, and subsequent guidance from the California Department of Tax and Fee Administration (CDTFA) that could clarify definitions, sourcing rules, exemptions, resale treatment, bundling rules, documentation requirements, and transition rules.