The two have reached an agreement in principle to merge with BA taking a 55% stake and Iberia a 45% slice.
The two airlines will retain their separate brands when the deal completes, which is expected to be late next year.
Willie Walsh, chief executive of BA, says the deal, which will require regulatory approval, “will create a strong European airline well able to compete in the 21st Century”.
The two already work together under the One World airline alliance, which allows them to sell seats on each other’s planes and held talks on a tie-up last year, while BA owns 13.5% of the Spanish carrier.
The proposed merger will create a new holding company called TopCo that will own both the existing airlines and whose shareholders will be the current BA and Iberia shareholders. Under the terms of the proposed merger, BA shareholders will receive one new ordinary share in TopCo for every existing BA ordinary share held by them and Iberia shareholders will receive 1.0205 new ordinary shares for every existing Iberia ordinary share held by them.
In a statement, the two airlines say the deal will save €400m (£357m) in costs per year.
The aviation industry has been hit hard by the global recession with the International Air Transport Association (IATA) predicting that the industry will lose $11 billion this year.
BA recently reported a £292m loss for the six months to 30 September and announced it is to cut a further 1,200 jobs, while Iberia announced it swung to a loss of €182m (£162.5m) in the nine months to 30 September, compared with a profit of €51.1m (£45.6m) a year ago
Walsh will be chief executive of the enlarged group while Iberia’s Antonio Vazquez Romero will be chairman.