Income from debt mutual funds including ultra short term funds, if held for less than 3 years, is classified as 'short term capital gains.' This is taxed at your slab rate just like income from savings bank accounts and fixed deposits (which is classified as 'other income'). However unlike savings account and FD income, this income can be set off against other short term losses including those of previous years up to as many as 8 years.
If on the other hand, you hold your funds for more than three years, the gains in them are taxed as long term capital gains at a rate of 20% (lower than the highest 30% tax slab). You also get the benefit of indexation which dramatically cuts the effective tax rate on them. Let's understand this looking at the computation of tax on an equal amount of income from each savings instrument (though of course debt funds yield much higher returns).
As the table shows, you pay as much as 27,000 rupees of tax on savings bank interest of 1 lakh and as much as 30,000 on FD income of 1 lakh. In comparison you pay just ₹4,153 for debt fund income above 1 lakh when it is held for more than 3 years. Also, in comparison to FDs, you do not have Tax Deducted at Source (TDS) cut from your gains from debt funds.
You may be puzzled by the fact that in this illustration, short term funds seem to carry a higher tax than savings bank accounts if held for less than 3 years. This is due to the ₹10,000 exemption on savings bank interest. However if you make more money in savings interest than that, the tax rate is the same. Nor can savings bank interest be set off against short term losses in the way that short term funds' gains can.