California’s SaaS Tax Raises the Stakes for Technology M&A
What California SB 122 Means for Dealmakers and Diligence
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October 01, 2026
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California recently ended one of the more significant remaining exclusions from its sales tax base, and the timing is notable for anyone active in software dealmaking.
On June 29, 2026, Governor Gavin Newsom signed SB 122, extending California’s sales and use tax to digital products, including software as a service (“SaaS”), effective January 1, 2027.1 For years, California stood out among large states for generally not taxing remotely accessed software. That treatment is now changing, and companies that sell SaaS to California customers or purchase it for California operations should be preparing for the change.
For corporate development teams, private equity (“PE”) sponsors and portfolio company CFOs evaluating software targets, this development belongs in the deal room, not just the tax department.
Key Takeaways for Deal Teams
- Classification drives everything. Whether an offering is taxable SaaS, excluded digital infrastructure or an exempt human-effort service depends on what a customer is actually buying. For artificial intelligence (“AI”)-enabled, managed-service and hybrid products, that may not be obvious from the product description.
- SB 122 creates a forward-looking diligence issue. The new rules become operative January 1, 2027, so diligence should emphasize compliance readiness while continuing the target’s ordinary historical sales and use tax review.
- Buyers of software have obligations too. When a vendor’s qualifying digital-product sales to one purchaser exceed $5 million in a calendar year, remittance responsibility shifts to the purchaser, who must hold a use tax direct payment permit and self-assess the use tax, unless a waiver is obtained from the California Department of Tax and Fee Administration (“CDTFA”) in advance.
- Customer address data is now tax-determinative. A purchaser’s address in the seller’s records determines both whether the sale is sourced in California and the applicable local rate.
- The rules are still being written. CDTFA has published proposed emergency regulations and solicited comment through an interested-parties process.2
What the Law Actually Does
SB 122 amends Revenue and Taxation Code Section 6016 to define “tangible personal property” to include a digital product and any associated copyright or patent interests.3 Beginning January 1, 2027, remotely accessed software falls within California’s existing sales and use tax framework, including its nexus, registration, exemption and permit rules. Sellers that have never registered in California may face new collection obligations, and purchasers may face new reporting obligations.
Scope and Exclusions
The law defines a digital product as prewritten computer software transferred on tangible storage media, transferred electronically or accessed remotely. It excludes seven categories: digital assets, digital audio works, digital audiovisual works, digital books, digital infrastructure, digital video game products and digital visual works.4 The digital infrastructure exclusion covers cloud-based services that allow customers to create, deploy, scale, or run their own software without managing the underlying infrastructure. Whether an offering falls inside or outside the exclusion often depends on the substance of the transaction rather than how a provider markets the product. When a single agreement covers both taxable software and excluded infrastructure, the classification question depends on the contract terms rather than the provider’s category.
The distinction between exclusion and exemption matters in diligence. An excluded product category falls outside the definition of a digital product entirely. An exemption applies to a product within the tax base and generally has to be substantiated, which makes it a documentation question rather than a one-time classification call.
Exemptions
Reproduction rights used to distribute copies to third parties remain exempt under SB 122, as do electronically delivered services that primarily involve human effort performed after a customer requests a service. However, the human-effort exemption does not apply to the right to use or access a provider’s software.5 Bundled service-and-platform offerings will therefore require contract- and invoice-level analysis. California regulations provide that charges for custom modifications to a prewritten program are nontaxable only if separately stated.6 The proposed regulations carry that rule forward for custom software but do not extend it to the human-effort exemption.7 CDTFA has indicated that the human-effort exemption will hinge on the transaction’s principal object, rather than simply how the charges appear on an invoice.8 While itemized invoicing is the defensible posture in either case, it does not by itself determine whether the exemption will apply. Custom software remains exempt, including separately stated modifications to prewritten software prepared to the special order of a customer, but only to the extent of the modification.9
Digital products purchased solely for use outside California or in interstate or foreign commerce are also exempt.10 The seller generally bears the burden of establishing the exemption unless it accepts a prescribed exemption certificate in good faith. However, a purchaser that provides a certificate and subsequently uses the product in California owes the sales tax on the price it paid. The statute authorizes CDTFA to establish alternative calculation methods for licenses available in multiple locations, and proposed Regulation 1600.2 supplies one:11 a purchaser may calculate the measure of tax that fairly reflects use inside and outside California using any reasonable, consistent and uniform method supported by its books and records.12 Allocation by users or computers is presumed reasonable, while allocation by server location is not.13 Electing an alternative method forfeits the credit for tax paid in another state at the time of sale.14
Rates and Sourcing
California’s current state sales tax rate is 7.25%, with combined state and local rates averaging roughly 9%15 and higher in some jurisdictions. For companies with meaningful California revenue, the potential cost can be material.
For digital products transferred electronically or accessed remotely, sourcing generally follows the purchaser’s address. The sale is sourced to the purchaser’s known California address in the seller’s records, under a stated priority: billing address, then shipping or delivery address, then the mailing address associated with the payment instrument, and, finally, the purchaser’s mailing address.16 If no California address can be identified, the sale is treated as occurring outside the state. A target’s customer address records therefore drive both the initial sourcing result and the applicable local rate. In diligence, buyers should test that data and separately assess actual user distribution, which may support a multistate-use position where reliance on a corporate headquarters address would otherwise overstate California use.
The $5 Million Shift
SB 122 also changes who may carry compliance risk. When sales of electronically delivered or remotely accessed digital products from a single retailer to a single purchaser exceed $5 million in the aggregate during the applicable calendar year, remittance responsibility generally shifts from the seller to the purchaser beginning with the transaction that crosses the threshold. The purchaser must obtain a use tax direct payment permit and self-assess the use tax.17 Alternatively, the purchaser may request a waiver from CDTFA, in which case the seller continues to collect the tax, but the waiver request must be submitted before any purchase to which it applies.18 That purchaser-side obligation belongs on a diligence checklist well before close of a transaction.
Timing: A Sector Already Under Pressure
Software was already under significant pressure in the private equity market heading into this change. According to PitchBook’s Q2 2026 U.S. PE Breakdown, software deal value fell to an estimated $10.7 billion, down 65.7% year over year and 90.3% below its Q3 2025 peak, as sponsors pulled back sharply from what had long been a core PE allocation.19 PitchBook’s Q1 2026 Enterprise SaaS M&A Review shows the same pattern on the sponsor side globally: PE buyouts in enterprise SaaS totaled just $19.9 billion, a second consecutive quarterly decline.20 Total enterprise SaaS M&A value was at a record for the quarter, but that figure was driven almost entirely by a single transaction; sponsor activity moved the other way.
That backdrop matters. California’s expanded sales and use tax base does not land on a sector at full strength. It lands on one already facing heightened underwriting scrutiny tied to AI disruption and financing costs. For legacy SaaS platforms with concentrated California revenue, buyers will need to revisit margin assumptions and may use the resulting cost or implementation burden in negotiations.
Three Considerations for the Deal Market
- Diligence must address both exposure and operational readiness. Once the changes reflected in SB 122 take effect, uncollected and unremitted California sales tax exposure on SaaS revenue becomes a quantifiable liability. Before any exposure begins to accrue, buyers should assess whether the target has classified its offerings, identified its California customer base, evaluated nexus and registration requirements, established sourcing and certificate procedures and configured its invoicing and accrual systems. A target that is not ready by January 1, 2027 may require an immediate post-close compliance build.
- Pricing and margin assumptions need testing. If the target plans to absorb the tax, the resulting cost may reduce net revenue, gross margin and EBITDA. If it plans to pass the tax through, the buyer should determine whether existing contracts permit the charge and whether higher customer costs could affect renewals, churn or future pricing. The model should therefore test both outcomes based on the target’s California revenue concentration, available exemptions and expected allocation of multistate licenses.
- Deal terms should allocate the transition and implementation risk. M&A transactions signed in late 2026 but closing on or after January 1, 2027 will cross the law’s operative date. Representations, interim operating covenants, indemnification provisions and transition services agreements should address compliance responsibility, billing-system changes and any exposure arising before closing. If the target is not operationally ready, the parties should determine who will fund and execute the required systems work and whether that cost should affect purchase price, closing conditions, or the post-close integration plan. Contract structure can affect how much of a target’s revenue the tax reaches, and when. Under the proposed regulations, the sale occurs when access transfers, not when payment is made, so a single-term license granted before January 1, 2027 stays untaxed for its term while a subscription is taxed period by period.21 A revenue-by-customer schedule may not show access transfer and payment details, so a review of the underlying contracts may be needed.
What Dealmakers Should Do Now
California’s move is not a reason to avoid SaaS targets with California exposure. It is a reason to quantify the cost and to treat the compliance build as a deal item rather than a post-close delivery. The statute does not resolve bundled offerings or the classification of cloud services as taxable software or excluded digital infrastructure. CDTFA is addressing these matters through rulemaking, though the department has said some questions may ultimately require legal opinions or litigation.22 CDTFA has published proposed emergency regulations and solicited comment,23 and plans to submit them to the Office of Administrative Law in early December,24 only weeks before the new rules take effect. Companies that cannot yet determine how their offerings will be classified have particular reason to track the rulemaking.
Footnotes:
1: S.B. 122, 2025–2026 Leg., Reg. Sess. (Cal. 2026).
2: CDTFA, Discussion Paper, “Application of Sales and Use Tax to Digital Products” (Sept. 1, 2026),CDTFA, Interested Parties Meeting Agenda, “Application of Sales and Use Tax to Digital Products” (Sept. 10, 2026).
3: Cal. Rev. & Tax. Code § 6016, amended by S.B. 122, 2025-2026 Leg., Reg. Sess. (Cal. 2026) (operative Jan. 1, 2027).
4: Cal. Rev. & Tax. Code § 6016.1(b) (2026).
5: Cal. Rev. & Tax. Code §§ 6362.4 and 6372.1 (2026); the human-effort exemption at Section 6372.1(a), with the carve-out for software access at subdivision (b).
6: Cal. Code Regs. tit. 18, § 1502(f)(2)(B) (2026).
7: Proposed Cal. Code Regs. tit. 18, § 1502.2(c), in CDTFA Discussion Paper, supra note ii.
8: Greenberg Traurig, “California SB 122 – CDTFA Workshop Addresses Software and SaaS Tax Rules Effective Jan. 1, 2027” (July 29, 2026).
9: Cal. Rev. & Tax. Code § 6010.9 (2026).
10: Cal. Rev. & Tax. Code § 6372(a) (2026).
11: CDTFA, Discussion Paper, Application of Sales and Use Tax to Digital Products, at PDF p. 16 (Sept. 1, 2026).
12: Proposed Cal. Code Regs. tit. 18, § 1600.2 (2026), in CDTFA Discussion Paper, supra note xi.
13: Proposed Cal. Code Regs. tit. 18, § 1600.2(d)(3)-(4) (2026), supra note xi.
14: Proposed Cal. Code Regs. tit. 18, § 1600.2(c) (2026), supra note xi.
15: Mandal, Abir, “State and Local Sales Tax Rates, Midyear 2026,” Tax Foundation (July 6, 2026).
16: Cal. Rev. & Tax. Code § 6010.5(b)(3) (2026).
17: Cal. Rev. & Tax. Code §§ 6052(a)(1)(A) and 6201.55(a)(1)(A), added by S.B. 122, 2025–2026 Leg., Reg. Sess. (Cal. 2026) (operative Jan. 1, 2027).
18: Proposed Cal. Code Regs. tit. 18, § 1600.1(c)(1), (d)(1), (d)(4)-(5) (2026), supra note xi.
19: PitchBook, "Q2 2026 US PE Breakdown" (July 6, 2026).
20: PitchBook, "Q1 2026 Enterprise SaaS M&A Review" (June 23, 2026).
21: Proposed Cal. Code Regs. tit. 18, § 1600(f)(2) and Examples 1, 3, and 5 (2026), supra note xi.
22: Greenberg Traurig, supra note vii.
23: CDTFA Discussion Paper, supra note ii.
24: Pope, David, et al., “California’s new digital products tax: Key points raised during CDTFA listening session,” DLA Piper (July 30, 2026).
The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals.
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