Taxation on FMPs depends on investment option the investor chooses - that is: dividend option or growth option. If the individual chooses dividend option, he does not have to pay tax since the dividend distribution tax is paid by the mutual fund. However, since the mutual fund has to pay tax it reduces the amount of dividend paid.
In the growth option, returns earned are treated as capital gains (short-term or long-term depending on the investment tenure).
In the case of short-term capital gains (i.e. if investments are held for less than 365 days), the interest income is added to the investor's income and is taxed at the applicable rate of tax.
As fas as long-term capital gains are concerned, if the investments are held for more than 365 days, the tax liability is determined based on indexation (charged at 20 per cent plus surcharge) and without indexation (charged at 10 per cent plus surcharge).
Interestingly, FMPs have the ability to be very tax efficient as you can have the double indexation benefit that comes into play.
Let's assume that you invested in a 14-month FMP of 400 days that was launched in March 2014 (FY13-14). It will mature in April 2015 i.e. FY14-15. While the investment is made in FY13-14, the redemption takes place in FY14-15. Thus, by investing in the FMP with maturity of 400 days, the purchase and sale years are spread over two financial years. Thus, double indexation comes into play, which effectively reduces one's tax liability.
For 13-14 the cost index inflation was 939, up from 852 in the previous year. This increase basically reflects inflation and can be added to claim indexation benefits, in case you opt for the same in FMPs.