California and Colorado Expand Sales Tax to Software Starting 2027: Understanding the Impact

Beginning January 1, 2027, California and Colorado will expand their sales and use tax rules to begin taxing software regardless of delivery method. This will include software-as-a-service (SaaS), cloud-based applications, electronically downloaded software, and software otherwise accessed remotely. While certain exemptions and carveouts will exist, they apply only in specific circumstances that are unlikely to affect most businesses and generally depend on proper documentation and contract language.

As software delivery has shifted from on-premises installations and transfer via physical media to cloud-based and subscription models, states have increasingly revisited how those transactions are taxed. To modernize their treatment of SaaS and keep pace with an increasingly digital economy, states that have historically focused on taxing sales of tangible property are expanding existing taxable categories (or creating new ones) to include SaaS.

For companies that sell software, these changes may create new tax collection, billing, sourcing, and compliance obligations. For businesses that purchase software, these changes mean that products previously bought tax-free may now be subject to sales or use tax, directly increasing costs and creating new self-assessment obligations. Organizations with significant software spend or multi-state operations should begin evaluating the potential impact before the new laws take effect.

Beginning January 1, 2027, California sales and use tax will generally apply to prewritten software regardless of whether it is delivered on physical media, electronically, or through remote access, including SaaS offerings.

For businesses, this means software arrangements that may not have historically been subject to California sales tax could require review. Companies should evaluate whether their software purchases or sales fall within the expanded rules, whether exemptions apply, and whether existing systems can support proper tax treatment.

One area likely to generate many questions is sourcing.

For electronically delivered or remotely accessed software, California sources the sale to the purchaser’s known address on file: billing address first, followed by shipping, payment instrument, and mailing address. That address controls the seller’s collection obligation. If the billing address is in Los Angeles, the seller looks to California on the transaction, regardless of whether the software is actually used across offices in six states.

This is the central tension SB 122 creates for enterprise and multi-seat licenses. A business with a California headquarters and users spread across the country may see its license sourced to California based on where the contract is billed, while other states apply their own sourcing rules to the same license. SB 122 contains no mechanism to apportion a single license price across the states where it is actually used.

CDTFA has named a regulation addressing digital products purchased for multiple points of use as part of its rulemaking package. Allocation based on user or device location and a purchaser-provided certificate have both been discussed, along with a post-sale refund or credit process as an alternative to allocation at the point of sale.

Businesses with enterprise or shared licenses should begin identifying where users and devices are located, and confirm whether their billing and contractual records could support an allocation if one becomes available.

Businesses that purchase more than $5 million in digital products from a single seller in a calendar year take on direct use tax remittance responsibility for the transaction that crosses that threshold, relieving the seller of its collection obligation on that sale. This shifts compliance from the vendor to the purchaser for the largest software buyers and should be factored into procurement and tax department workflows before January 1, 2027.

California continues to exempt custom software developed to the special order of a customer. This is important because many organizations use a mixture of commercially available software and customized solutions. It is important to note that this specifically excludes any form of canned software that could be used across multiple clients.

The legislation also excludes categories of digital products that fall outside the statutory definition of software. Of note is the ‘human effort’ exemption, which applies where a service primarily involves human effort by the provider, originating after the customer’s request. A telehealth platform, for example, may qualify where the software is incidental to the professional service being delivered.

Colorado’s legislation follows a similar philosophy but uses a different framework.

Beginning January 1, 2027, software delivered through physical media, downloads, mobile applications, and remote internet access generally becomes subject to sales and use tax.

Compared to California, Colorado repeals an existing exemption rather than creating a new tax framework, applies a far lower base rate (2.9% vs. California’s 7.25%), and layers on the added complexity of home-rule cities that may already tax software independently of the new state law.

Colorado preserves exemptions for:

However, businesses should not assume these exceptions automatically apply. Documentation and contract language may become increasingly important to determine the tax burden.

The expansion of SaaS taxation is not only a tax department issue. These changes may affect budgeting, procurement, accounting, IT, legal, and operations.

For companies that purchase software, the impact may show up as higher costs or increased use tax obligations. For companies that sell software, the impact may involve registration, collection, billing, and compliance updates. For multi-state businesses, the challenge may be determining where software is used and how transactions should be sourced.

Organizations should begin evaluating:

Even companies with modest software budgets may experience increased costs depending on their software mix.

Vendors selling into California or Colorado should consider:

SaaS providers will need to determine whether products that were previously treated as non-taxable will now be taxed.

Organizations with employees, customers, or operations across multiple states may face additional complexity as states continue to expand taxation of SaaS and remotely accessed software.

Businesses should consider:

As software tax laws continue to evolve, reviewing these processes can help businesses identify potential exposure and prepare for future compliance requirements.

Questions about how California SB 122 or Colorado HB 26-1223 could affect your business? Reach out to a Sensiba state and local tax professional to discuss your specific situation and potential next steps.