California Gov. Gavin Newsom unveiled a new 2026-27 state budget proposal last week. It aims to “fully eliminate” California’s projected deficit through July 2028 while protecting core services. How?

There is a significant proposal to expand Californian sales tax that may affect many Israeli (and other) software companies. He is a review of comments from the Legislative Analyst’s Office (LAO), a California nonpartisan fiscal and policy adviser.

Newsom’s proposal: He proposes extending the state’s 7.25% sales tax to sales of pre-written software broadly, no matter how the software is delivered.

Until now, California’s sales tax has applied to software transmitted on tangible media. It does not apply to other sales of software, such as custom software, pre-written downloaded software, or pre-written software accessed remotely.

Custom software designed for an individual client would remain exempt.

The change would go into effect January 1, 2027. Newsom’s administration estimates that this would raise local sales-tax revenue by $560 million in 2026-27, when it would be in effect for half a year. The full-year revenue estimates for 2027-28  range up to $1.1 billion in local sales-tax revenue.

When California introduced its sales tax nearly a century ago, consumers spent most of their money on tangible goods, according to the LAO. The state further aligned the sales tax with consumption by excluding sales for resale – including raw materials and component parts – from the tax base.

Over time, however, the economic importance of tangible goods has declined, outpaced by growth in services and digital products. This trend has weakened the link between consumption and California’s sales-tax base in two ways:

• A growing share of consumption falls outside of the sales-tax base. In some cases, such as pre-written software delivered through different means, the distinction between taxed and untaxed sales is very difficult to justify.

• Many of the tangible goods used to produce other goods and services are not eligible for the sales for resale exclusion. There are partial exemptions for certain items used in production, such as farm equipment and manufacturing equipment.

By focusing on software alone, Newsom’s proposal would address one type of inconsistency between digital and conventional products, but other significant discrepancies would remain. Growth in the digital economy has included not just software but also other types of digital products, such as text, audio, and video files.

A large share of the newly taxed transactions likely would be business-to-business sales. Taxes on business-to-business sales might seem appealing, because the resulting costs to consumers are less direct and perhaps less salient.

Since the mid-20th century, many countries (including Israel) have implemented value-added taxes (VAT), which are designed to avoid taxing business-to-business sales.

The LAO recommends that the legislature consider an approach like the ones taken by Connecticut, Iowa, Maryland, and New Jersey, which have exemptions or reduced rates for software.

Comments: The LAO mentions but doesn’t explain that “businesses often pass such taxes on to consumers anyway.” Our guess is that this means the Californian proposal, if adopted, won’t really collect more sales tax; it might merely collect it earlier in the supply chain. If so, more sales tax might be collected before July 2028 that would otherwise be collected after July 2028, which the next California governor may have to deal with.

What about Israeli suppliers of pre-written software? They may soon face the 7.25% sales tax regardless of how the software is supplied. But there may still be loopholes for customized software and other types of digital products, such as text, audio, and video files.

There may be other issues to check out. For example, what about software not downloaded but operated on a cloud outside California?

It remains to be seen what is legislated – in California and perhaps in other US states if they follow California’s example.

Assuming the Californian proposal is passed, what should an Israeli software company do before implementation, which is expected in January 2027?

First, check with Californian advisers whether the proposed new tax applies to their activity? Can the activity be modified for California customers?

Second, US sales tax cannot be credited against Israeli income tax or company tax. If the sales tax will apply, there may be a choice between passing the tax onto customers or swallowing it and reducing profits.

As always, consult experienced tax and professional advisers in each country at an early stage in specific cases.

leon@hcat.co

The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.