Coming Attractions: California Previews Rules on SaaS and Digital Products Tax

California has taken another significant step toward implementing Senate Bill (SB) 122, which expands the application of California sales and use tax to software as a service (SaaS) and certain digital products by treating qualifying digital products as tangible personal property for tax purposes. On September 1, 2026, the California Department of Tax and Fee Administration (CDTFA) released a discussion paper containing draft emergency regulatory language intended to clarify how the agency may administer the new law when it becomes operative on January 1, 2027. CDTFA walked stakeholders through the proposals in detail during a September 10, 2026, interested parties meeting and is accepting comments through September 24, 2026.

The draft regulations provide important insight into CDTFA's current interpretation of SB 122 and address many of the questions raised by taxpayers, software providers and purchasers since enactment of the legislation. At the same time, the proposals highlight significant compliance, sourcing and reporting challenges that businesses may face beginning in 2027.

SaaS Clearly Remains the Primary Target

Perhaps most notably, proposed Regulation 1600 would confirm that SaaS is a taxable digital product, while infrastructure as a service and platform as a service remain excluded. The draft language also addresses transactions involving electronically transferred software. For example, mandatory maintenance agreements, license fees and other nonoptional charges would generally remain included in the taxable measure.

Additionally, CDTFA's draft includes detailed rules for determining when a taxable transaction occurs, including guidance for subscription-based arrangements that span the January 1, 2027, effective date. Under the draft, payments attributable to subscription periods before January 1, 2027, would not be taxable, but payments covering periods on or after that date generally would be subject to tax.

Multistate Use Receives Long-Awaited Attention

SB 122 created an exemption for digital products purchased solely for use outside California but did not establish a clear framework for software licenses used across multiple jurisdictions. In response to comments CDTFA received during its July 2026 workshop, including suggestions that CDTFA adopt a multiple-points-of-use framework similar to those used in other states, proposed Regulation 1600.2 would authorize such a methodology.

Under the proposal, purchasers would be permitted to allocate software costs using a reasonable, consistent and documented method that reflects California usage. User-based allocation is identified as presumptively reasonable, while allocation based on server location is not, though the proposal stops short of mandating any single method. This flexibility could prove particularly important for businesses with geographically dispersed workforces and enterprise software agreements covering users across multiple jurisdictions.

Although the proposal represents a significant step toward administrability, it also places substantial responsibility on taxpayers to maintain supporting documentation and develop defensible allocation methodologies. Businesses with large multistate software deployments may wish to begin evaluating those methodologies now rather than waiting until 2027.

CDTFA Signals a Narrow View of the Custom Software Exclusion

The draft regulations reaffirm a traditional and relatively narrow interpretation of California's custom software exclusion. Software generally qualifies only if it is prepared to the special order of a single customer. CDTFA's examples suggest that software licensed broadly to multiple customers remains taxable prewritten software even where outputs appear highly tailored or incorporate customer-specific functionality.

The agency's discussion of artificial intelligence-enabled software is particularly notable. CDTFA's example indicates that training software on California-specific tax law does not transform an otherwise taxable software product into exempt custom software merely because the resulting outputs appear individualized. This guidance suggests CDTFA intends to focus on how software is developed and marketed rather than on the personalization of its results.

Large Purchasers Face New Compliance Obligations

Under the proposed rules, once purchases of electronically transferred or remotely accessed digital products from a single retailer exceed $5 million, responsibility for reporting and remitting tax generally shifts from the retailer to the purchaser. The purchaser must then obtain a use tax direct payment permit or seek a waiver from CDTFA.

CDTFA's proposal largely follows the statutory framework established by SB 122. As a result, affected purchasers may need new processes for tracking vendor spend, monitoring threshold calculations, issuing certificates and self-assessing tax liabilities.

Other Proposed Changes

CDTFA's draft package also touches several related regulations. Proposed Regulation 1600.3 would implement the exemption for digital products purchased solely for use outside California or in interstate or foreign commerce, requiring sellers to obtain a timely, good-faith exemption certificate from the purchaser.

Amendments to Regulation 1507 would clarify that the technology transfer agreement framework, which can allow taxpayers to exclude licensed copyright or patent value from the taxable measure, does not apply to prewritten software sold with associated intellectual property interests. That transaction type would instead be governed exclusively by new Regulation 1600.

Finally, Regulation 1502 would be renamed "Data Processing" and streamlined, relocating its software-related provisions to new Regulation 1502.2 and the regulations above, and amendments to Regulation 1699.6 would update the use tax direct payment permit process to account for digital product purchases.

Holland & Knight Insight

CDTFA's draft regulatory language attempts to address several questions left unresolved by SB 122, particularly regarding SaaS subscriptions, multistate usage, custom software, technology transfer agreements and purchaser compliance. However, it also underscores the compliance burden many businesses will face beginning January 1, 2027.

Businesses should review the draft language, evaluate whether their offerings qualify as taxable digital products or exempt services, reassess any technology transfer tax positions, evaluate multistate sourcing methodologies, and prepare for new certificate and recordkeeping requirements. Because CDTFA has not yet formally proposed these regulations and the language may change, businesses should continue monitoring developments. Written comments pertaining to CDTFA's draft rules are due to CDTFA by September 24, 2026.

For more information, please contact the authors.

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