Update: On June 29, 2026, California Governor Gavin Newsom signed SB 122 into law.

On June 18, 2026, the California legislature passed and sent to Governor Gavin Newsom Senate Bill 122 (SB 122), the state's budget trailer bill for the 2026-27 fiscal year. SB 122 would expand the state's sales and use tax base to include digital products such as prewritten software and software as a service (SaaS), extend the existing limitation on utilizing business tax credits and reduce the first-year minimum annual tax for certain pass-through entities.

The governor has 12 days to act on SB 122. If approved, SB 122 would become law immediately but would not be effective until January 1, 2027.

Below is a summary of the key changes in SB 122.

Expansion of sales and use taxes to digital prewritten software and SaaS

SB 122 would redefine "tangible personal property" for sales and use tax purposes to include a "digital product" and any copyright or patent interests associated therewith. A "digital product" would be defined as prewritten computer software transferred on tangible storage media, transferred electronically, or accessed remotely, which would encompass SaaS. This expanded definition would be operative for transactions occurring on or after January 1, 2027.

This expansion would bring California in line with a growing number of states that have extended their sales and use tax bases to include electronically delivered software and cloud-based offerings. SB 122, however, does not expand the tax base to transactions involving other products of a digital nature (e.g., digital books, video games, cryptographically secured digital assets, certain digital infrastructure offerings, and audio, visual, and audiovisual works). The nontaxability of custom software transactions is unaffected by SB 122.

Vendors and purchasers should be aware that local taxes under the Bradley-Burns Uniform Local Sales and Use Tax Law and district taxes under the Transactions and Use Tax Law would automatically conform to this law change. Thus, local and district taxes would also apply to retail sales of digital products as defined. Except for in-person transactions, destination sourcing of local and district taxes for taxable sales of digital products transferred electronically or accessed remotely would be mandated through a hierarchy of "known addresses," which would deviate from the Streamlined Sales and Use Tax Agreement (SSUTA) rules. In addition, SB 122 would prohibit any purchaser or retailer from entering into a local tax revenue-sharing agreement with a local agency for taxable purchases or sales of digital products that are transferred electronically or accessed remotely.

This expansion also would abrogate the exclusion from tax that currently exists for certain retail sales, commonly known as software technology transfer agreements (TTAs), that are entered into on and after January 1, 2027. In the absence of an applicable exemption, tax would apply to continuing software TTA leases for all lease payments due on and after January 1. 2027. Pending or future software TTA refund claims for transactions completed before January 1, 2027, would be resolved under current law.

Under specified circumstances, the purchaser may be required to obtain use tax direct pay permits and to self-report use tax on such purchases.

SB 122 contemplates multiple-points-of-use exemption certificates (similar to the SSUTA's regime) and credit offsets for tax paid to other states for the sale and purchase of digital products, but the specific rules for these elements will likely be developed through an interested-parties process with the California Department of Tax and Fee Administration in the coming months.

SB 122 would exclude from use tax the temporary storage of software on servers in California for deployment and functional use outside the state.

"Golden master" transactions (i.e., sales of digital products to purchasers that will effectively resell the digital products to third parties) would continue to be exempt from California tax.

Temporary extension and modification of the limitation on business income tax credits

Existing law, for tax years beginning on or after January 1, 2024, and before January 1, 2027, limits the use of business tax credits to $5 million per tax year, with only a narrow exclusion for certain business tax credits. (See Tax Alert 2024-1299.) The $5 million limitation is applied on a combined group basis such that the aggregate tax of all members of the combined reporting group cannot be reduced by more than $5 million due to tax credits.

SB 122 would extend this $5 million limitation through tax years beginning before January 1, 2030. As under current law, the carryforward period for unused credits resulting from the limitation would be extended by an additional year for each year the limitation affects the credit.

The period for making an irrevocable election to receive an annual refundable credit amount (equal to 20% of the qualified credits that would have otherwise been available but for the $5 million limitation) would be extended three years through tax years beginning before January 1, 2030. The annual refundable credit amount would be allowed as a credit beginning the third tax year after the election is made.

Effective for tax years beginning on or after January 1, 2030, SB 122 would modify the business credit limitation so it would equal the greater of 70% of the total taxes imposed or $5 million per tax year, with only a narrow exclusion for certain business tax credits. Unlike prior limitations, the modified limitation would apply permanently. SB 122 would not, however, extend a taxpayer's ability to elect to receive an annual refundable credit for tax years beginning on or after January 1, 2030.

Like the current credit limitation, the new credit limitation would affect both corporate and personal income taxpayers. The corporate tax credits affected by this limitation include, but are not limited to, the following: the research and development credit, the jobs tax credit, the California competes credit, and the motion picture production credits. This limitation would not apply to the low-income housing tax credit. The personal income tax portion would exclude 11 specified credits from the limitation, including the California pass-through entity tax credit, earned income tax credit and renter's tax credit, among others.

Because the extension of the credit limitation would overlap with the tax years in which the annual refundable credit is allowed under the current credit limitation, the bill would make clear that the annual refundable credit amount is not included in the SB 122 $5 million limitation for 2027–2029.

Reduced first-year minimum annual tax for pass-through entities

Existing law imposes an annual minimum franchise tax of $800 on every corporation incorporated in, qualified to transact business in, or doing business in California, and an annual tax in an equal amount on every limited partnership (LP), limited liability partnership (LLP) and limited liability company (LLC) doing business in the state.

SB 122, for tax years beginning on or after January 1, 2027, and before January 1, 2030, would reduce the annual tax imposed on an LP, LLP and LLC from $800 to $400 for the entity's first tax year.

Implications

The sales and use tax expansion to digital prewritten software and SaaS would represent a significant change for the technology sector and any business that purchases or sells software in California.

Affected taxpayers may want to consider the following steps:

• Identify offerings that constitute digital products, including electronically downloaded prewritten software, remotely accessed SaaS (including AI-enabled offerings), and purchases of equipment with licensed embedded software to assess current and future sales-and-use-tax treatment
• Evaluate systems and billing processes to determine whether they can distinguish taxable digital products transactions and apply sales and use tax appropriately, beginning January 1, 2027
• Evaluate accrual processes to identify taxable digital products purchases and prepare to self-assess use tax where needed
• Consider the potential impact on pricing, contract terms and planning for transactions occurring on or after January 1, 2027
• Monitor subsequent guidance from California Department of Tax and Fee Administration regarding definitions, sourcing rules, exemptions, resale treatment, bundling rules and any transition rules

In the May revision of his budget proposal, the California governor called for a permanent credit limitation starting in 2027 based on the greater of 50% of the tax liability paid or $5 million, with no related refundability. SB 122 instead extends the $5 million limitation through 2029 but at least allows taxpayers to elect to have limited credit refunded through 2029, if the related requirements are met. However, beginning with tax year 2030, California taxpayers will face a permanent credit limitation based on the greater of 70% of the tax liability paid or $5 million with no ability to have limited credit refunded.

While California taxpayers may be used to the legislature periodically limiting credits to address budget shortfalls, the prospect of a permanent credit limitation could cause taxpayers to reconsider the value of their California business tax credits.