California's New Digital Product Tax Law (SB 122): What Businesses and Buyers Need to Know Before 2027

On June 29, 2026, Governor Gavin Newsom signed Senate Bill 122 into law, expanding California's Sales and Use Tax to cover software and digital products that have largely avoided state sales tax for years. If you run a business, buy cloud software, or manage purchasing decisions in California, this changes your costs starting January 1, 2027 — whether you've heard about it yet or not.

What Counts as a "Digital Product" Under SB 122

The law redefines "tangible personal property" for sales tax purposes to include a new category: the digital product. Knowing exactly what falls inside — and outside — this definition is the difference between budgeting correctly and getting hit with an unexpected invoice.

Where the Tax Applies: Destination-Based Sourcing Rules

SB 122 applies destination-based sourcing rules to digital product sales. In plain terms: for electronically transferred or remotely accessed software, the sale is sourced to the buyer's known address, based on records the seller maintains during normal business operations.

This also means local and district sales taxes apply to digital purchases — not just the statewide rate. Depending on your business's billing address in California, your effective tax rate on software could vary by jurisdiction. The law also blocks any local revenue-sharing agreement between a buyer or retailer and a local agency specifically for taxable digital transactions, closing a loophole before it could be used.

The $5 Million Exemption Threshold — And Why It Can Shift the Burden to You

Here's the detail most coverage of this law misses, and it matters if you're a buyer, not just a seller. A retailer is exempt from collecting tax on electronically transferred or remotely accessed digital products if their gross receipts from such sales exceed $5 million in the current calendar year (or, starting January 1, 2028, in the current or prior year).

When that threshold is crossed, the obligation doesn't disappear — it shifts to the buyer. The purchaser becomes responsible for calculating and paying use tax directly to the California Department of Tax and Fee Administration (CDTFA).

The $5 million threshold isn't frozen — it will be adjusted every five years based on the percentage increase in the California Consumer Price Index.

Exemptions for Out-of-State and Interstate Use

SB 122 exempts digital products purchased exclusively for use outside California, or for interstate or international commerce. However, the burden of proving that exemption falls on the seller — unless the buyer provides a valid exemption certificate confirming the product was acquired exclusively for out-of-state or interstate use. The CDTFA is responsible for prescribing the official forms needed to claim this. A credit is also allowed for retail sales tax already paid to another state on the same transaction, preventing double taxation.

Corporate Tax Credit Cap Extended to 2029 — Then Made Permanent

Before SB 122, California limited the use of business tax credits — for both corporate and personal income tax — to $5 million per fiscal year, covering 2024 through 2026, applied to the group's aggregate net tax as a whole. SB 122 extends this $5 million cap through fiscal year 2029. The carryforward period for unused credits is extended by one additional year for every year the cap impacts credit usage, and the window to elect an annual refundable credit (20% of otherwise available qualified credits) is also extended through 2029.

Credits affected include the R&D credit, the job creation credit, the California Competes credit, and film production credits. Credits excluded from this limitation include the Pass-Through Entity (PTE) tax credit, the Earned Income Tax Credit, and the renter's tax credit.

Good News for New Businesses: Franchise Tax Cut in Half

If you're planning to form an LLC in California in the next few years, timing your formation within this window cuts your first-year state filing cost in half — a real reduction in one of the highest business formation costs in the country. If you're weighing that decision against how to finance your first year of operations, running the numbers through a business loan cost simulator before committing shows the real total cost, not just the advertised rate.

SB 122 Key Dates at a Glance

What to Do Before January 2027

• Ask every software vendor whether their digital product sales exceed $5 million a year — if so, you may owe use tax directly to the CDTFA
• Request exemption certificate forms now if you buy software used exclusively outside California
• If forming an LLC, check whether timing your registration in the 2027–2029 window qualifies you for the reduced $400 franchise tax
• Model your true first-year costs with the California Financial Simulator before committing to financing
• Check your business banking setup with our Bank Comparison Tool ahead of new compliance costs

Frequently Asked Questions

Official source: California Department of Tax and Fee Administration (CDTFA). Verify current guidance directly with the CDTFA before making tax decisions, as implementation rules may be updated before January 2027.