generally, I place it in the 2nd ring of cities.
There are two types of corruption in Civ III, and they add together. There is distance corruption (how far a city is from the palace or the forbidden palace) and rank corruption (how many cities are closer to the capital than the city being looked at)
If you put the forbidden palace a long way from your capital, you will reduce distance corruption in the cities right near by, but it's likely not to matter, because there will be a lot of cities closer to the regular palace, so the rank corruption will be ruinous. But if you put it relatively close to the palace, the cities right near it will get a little bump.
Most important is having it, though. Rank corruption has what I call a tipping point. Cities founded with a higher rank than that tipping point will have ruinous corruption. The FP raises that tipping point considerably.