TALKS with China National Aviation Corp (CNAC) for it to buy a 6 per cent stake in Hong Kong Dragon Airlines failed because the mainland company wanted a bigger slice than permitted by an obscure Hong Kong law, sources close to the talks say. A little-known regulation, which will cease to exist from the June 30 handover next year, stipulates that all Hong Kong-based airlines operating scheduled services must be more than 50 per cent owned by British-backed companies or persons holding full British passports. Written into air services agreements, it means that if Dragonair's shareholding was reduced to less than half British-controlled, it would not be able to fly to some of its 21 destinations for the next 17 months. Sources said the sale of the 6 per cent on offer by Swire Pacific and Cathay Pacific Airways to CNAC would have called for some 'rejuggling' of the existing shares to make them British-controlled, as Dragonair is about 54 per cent British. Any larger amount would have been impossible to work out before the handover, the sources said. CNAC, which has filed applications to the Government to launch a new airline in the territory to be known as China Hongkong Airlines, had wanted more. It had been believed that Dragonair was predominately Chinese-owned, because Beijing's investment arm, Citic Pacific, holds 46 per cent while Swire and Cathay together hold 43 per cent. The remaining share make-up was not clear. The airline has always said 5 per cent was held by the 'family' of pro-Beijing textile magnate Chao Kuang-piu, a founder of Dragonair, and the remaining 6 per cent by 'small investors'. Sources said the 5 per cent Chao stake was held by Mr Chao's son, who holds a British passport. Most of the remaining 6 per cent is held in an unlisted Hong Kong-registered company, the owners of which are British with close connections to Swire. Swire, which controls 52 per cent of Cathay, would not say whether talks with CNAC had broken down, and said the 6 per cent stake offer was 'still on the table'. It is understood to have been valued at about $400 million. Management privately has expressed concern that CNAC, having had access to Dragonair's closely guarded books that show which routes are its most profitable and how it operates, will build a 'copycat' airline aimed at bringing down Dragonair. It aims to start on April 1 with charter flights to China, which are not affected by the obscure law. CNAC, controlled by the regulatory Civil Aviation Administration of China (CAAC), has secured its first aircraft and hopes to have its application to begin flights approved by the end of next month. Industry magazine Flight International said in its latest issue that China Hongkong was about to sign a five-year lease agreement with General Electric Capital Aviation Services of the United States for a three-year-old Boeing B737-500 previously operated by a Mexican carrier.