China could make billions of dollars from taxing gains made by employees of e-commerce giant Alibaba Group (BABA.N) who are free to sell their shares for the first time since its IPO, as the country tightens up its leaky mechanisms for tax collection.

On Wednesday, a six-month lock-up period for the recently New York-listed stock expired, allowing insiders who bought 437 million shares prior to the IPO to sell their stock, though 100 million of them are subject to trading restrictions that apply to employees until the company reports results in May.

The total lock-up represents roughly 18 percent of Alibaba's shares, which if sold would fetch just over $37 billion at Friday's closing price.

Although Alibaba did not disclose the identity of the shareholders subject to the lock-up, many will be taxable in China, where most of its 22,000 people are employed, and its share scheme is subject to a number of controls that will help ensure China gets its tax.

Current and former employees hold around 26.7 percent of the company, having built up holdings through stock options and other incentives since 1999, according to a Reuters report from June using IPO securities filings.

Those subject to the expiring lock-up will have obtained their shares at different times and costs, so the gains figure is unknown, but the tax is expected to reach billions of dollars for China's State Administration of Taxation (SAT).

While tax on employee compensation is withheld by employers, tax on share sales must be declared by employees, meaning it's typically harder for the authorities to track.

It is not uncommon for employees participating in Chinese company stock incentive schemes to transfer their shares to offshore trusts in the Cayman or British Virgin Islands to avoid tax, according to a person who helps create such structures.

But Alibaba's newly minted millionaires won't escape the gaze of the tax inspector, said a Beijing-based accountant.

"Because it was such a large IPO, the tax bureau will for sure be monitoring that."

PREPPED AND POISED

Jacky Chu, a partner in the China tax practice at PwC, said the SAT was very familiar with this kind of stock option arrangement and would be poised to act.

"The tax officials are smart enough to know that there should be money coming in, and over the last few years the SAT has been targeting equity income," he said.

A spokesman for Alibaba said employees were responsible for reporting share sale gains to the tax authorities, but the company had registered its stock incentive plan with the State Administration of Foreign Exchange (SAFE), which controls how much money goes in and out of China.

It added that Alibaba "withholds capital gain tax from proceeds of share sales that can be repatriated back to China" through a channel stipulated by SAFE.

    Although the United States does not generally tax non-resident foreigners on profits from the sale of U.S.-listed shares, China taxes Chinese residents 20 percent on capital gains, wherever made.

While the potential tax windfall is tiny relative to China's total fiscal revenue of 14 trillionyuan ($2.26 trillion) last year, it reflects the government's more rigorous stance on tax.

According to U.S. securities filings, Alibaba employees who participated in the company's stock incentive schemes and who are Chinese citizens or year-long residents were required to register with SAFE once the company went public.

"Failure to complete the SAFE registrations may subject them to fines and legal sanctions and may also limit the ability to make payment under our equity incentive plans or receive dividends or sales proceeds," the document said.

SAFE did not respond to requests for comment. The SAT would not comment on Alibaba but confirmed overseas gains by Chinese residents are subject to 20 percent tax.

A larger lock-up of more than a billion shares held by insiders including founder Jack Ma and Yahoo! Inc (YHOO.O) expires in September.

($1 = 6.1954 Chinese yuan renminbi)