California’s New Sales Tax Rules for Digital Products

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What Investment Management Companies Need to Know

California’s recently signed Senate Budget Bill 122 (the Bill) includes one of the most significant expansions of the state’s sales tax base in decades. You can read more about the Bill in our recent article, California Budget Bill Affecting Digital Products and Other Businesses. While much of the attention has been focused on technology companies and software providers, investment management firms would be wise not to overlook the potential impact this proposal could have on their management company.

Although traditional investment advisory services generally remain outside the scope of California sales tax, hedge fund, private equity and venture capital management companies operate as technology-enabled businesses. From investor portals and proprietary research analytics to cloud-based software and artificial intelligence platforms, many management companies are consumers and in some cases providers of digital products and services. As a result, firms should begin evaluating how the proposed legislation could affect their compliance obligations.

Investment Management Fees Remain Generally Unaffected

The good news is that the Bill is not intended to impose sales tax on traditional investment advisory services. Fees earned for investment management services, due diligence or investor relations appear to remain outside California’s sales tax regime.

The Technology Surrounding Investment Management May Be a Different Story

Over the past decade, several management companies have evolved beyond just providing traditional investment management or advisory services by developing proprietary technology, investor reporting platforms, benchmarking tools and AI-enabled applications. While these tools are often provided as part of an overall advisory relationship, some management companies separately license or commercialize their technology.

PKF O’Connor Davies Observation

Management companies that have developed proprietary software should review whether any portion of their technology offerings could be considered taxable digital products. Firms should review all revenue streams to determine whether any separately marketed or licensed technology could fall within California’s expanded sales tax base. Identifying these offerings now will help management evaluate potential collection obligations and avoid compliance surprises if the legislation is enacted.

Bundled Services Require Careful Review

Many management companies provide their investors with online access to quarterly reports, capital account statements, tax documents, and portfolio information through secure web portals. If these services remain incidental to the investment advisory relationship and are not separately stated on the invoice, they are generally expected to continue to be treated as part of the overall professional service.

However, firms that separately charge for access to proprietary software, analytics platforms, reporting systems, data subscriptions and research tools should review whether these offerings may become taxable under California’s expanded rules. Proper contract drafting and invoice presentation will become increasingly important.

PKF O’Connor Davies Observation

The manner in which services are described in engagement letters, contracts, subscription agreements, invoices, and marketing materials will become increasingly important. Firms should review whether technology is being sold as a standalone product or provided as an integral component of a broader investment advisory engagement. Careful drafting and consistent billing practices may help reduce uncertainty under the new rules.

California Nexus Considerations

Many non-California domiciled management companies assume that California sales tax rules do not apply to them because they lack a physical office in the state.  However, California’s economic nexus rules could apply when a business exceeds the applicable sales threshold. Firms that license software or digital products to California customers — even without a physical presence — should determine whether they have California sales tax collection obligations.

PKF O’Connor Davies Observation

Although additional guidance is expected, management companies should begin preparing now by evaluating both their technology offerings and software procurement practices. Taking a proactive approach can help identify potential compliance issues, optimize the structure of technology-related transactions and minimize sales tax exposure before the new rules become effective.

Final Thoughts

For most hedge funds, private equity and venture capital management companies, the proposed legislation is not expected to affect traditional investment management fees. Firms should not assume, however, that they are insulated from its broader implications.

As investment managers continue to expand their use of proprietary technology, artificial intelligence and cloud-based platforms, the distinction between nontaxable professional services and taxable digital products is likely to become increasingly important. Firms that develop proprietary software, provide technology-enabled services or license digital tools may face new sales tax considerations under California’s evolving rules.

Accordingly, now is an appropriate time for management companies to evaluate their technology offerings, review software procurement practices and expenditures and assess whether California’s changing sales tax landscape could create additional compliance obligations or planning opportunities.

Contact Us

If you have any questions, please contact your PKF O’Connor Davies client service team or: 

Alan S. Kufeld, CPA
Partner
akufeld@pkfod.com | 646.449.6319

Steven J. Eller, CPA, JD
Partner
seller@pkfod.com | 551.249.1836