Section 3 is worded as:
For the purposes of this Act, “previous year” means the financial year immediately preceding the assessment year :
Provided that, in the case of a business or profession newly set up, or a source of income newly coming into existence, in the said financial year, the previous year shall be the period beginning with the date of setting up of the business or profession or, as the case may be, the date on which the source of income newly comes into existence and ending with the said financial year.
[The section was last ammended by Finance Act, 1999. As per the original section, the option was there with the assessee to select previous year itself and to opt for different Previous year for different source of income. The same was then streamlined by Direct Tax Laws (Amendment) Act, 1987.]
As per the section, the previous year is generally the financial year immediately preceding the assessment year. Thus it is the fixed period of twelve months. Irrespective of the financial year adopted by the person, the previous year as per the Income Tax Act, shall remain the same.
However, if the business is newly set-up or source of income newly coming into existence, the previous year shall begin from the date on which such business or source of income is coming into existence and will end up with the said financial year.
With the literal reading, it could have absurd interpretation. According to it, every existing assessee having a new business or new source of income coming into existence during the normal previous year, could have different and shortened the previous year than the normal one. This could result into escape taxation due to shortened previous year as the income earned in the period before setting up new business or before the existence of newly source of income is not covered in the previous year.
However, the intent is to apply the law on the business newly set up or the newly source of income for the period specified and not for the whole year.
For example, a person who is having a goods carriage for the whole year, but would have set-up a business in the month of Feb and is assessing income under section 44AE, then previous year would start from the Feb and income shall be presumed accordingly and not for the whole financial year.
It has to be understood that, once the business is incorporated, its income would not start to assess unless the business is set-up, and once the business is set-up, its income would be assessed and the assessee can also claim for the expenditure incurred. However it is also important to understand the difference between Commencement of business and set up of the business.
It is only when a business is established and is ready to commence that it can be said of that business that it is set up. Before it is ready to commence it is not set up. [CIT v. Sarabhai Sons (P.) Ltd.  90 ITR 318 (Guj.)]
Few important case studies to understand the intent and impact of the law:
- Where business of generation of power was not set up during relevant financial year(s), interest income from fixed deposit on temporarily placing of fund with bank, would be reduced from capital cost of project instead of taxing it as income from other sources. Prayagraj Power Generation Co. Ltd.
- Acts of applying for participation in tender, borrowing of fund on interest from holding company and deposit of borrowed monies on same day as earnest money clearly establish that business had been set-up by assessee in relevant year. Dhoomketu Builders
- In case of assessee, an asset management company, date of approval given by SEBI was to be regarded as date on which assessee set up its business and was ready to commence said business and, therefore, expenses incurred for purpose of business after said date of approval were eligible for deduction under section 37(1). PPFAS Asset Management Company