British Airways and Iberia tonight agreed the basis for a proposed merger expected to be completed in late 2010, a BA spokesman said.
The proposed merger would create an airline group with 419 aircraft which would fly to 205 destinations.
BA chief executive Willie Walsh said: "The merger will create a strong European airline well able to compete in the 21st century.
"Both airlines will retain their brands and heritage while achieving significant synergies as a combined force."
The statement from BA said its board had agreed a binding memorandum of understanding with the board of Iberia.
It sets out the basis for a proposed merger of the two companies which last year carried 62 million passengers and had joint revenues of approximately 15 billion euros in their last financial years.
The statement said the airlines believe "there is a compelling strategic rationale for the transaction which is expected to generate annual synergies (savings) of approximately 400 million euros and benefit both companies' shareholders, customers and employees".
A BA spokeswoman could not rule out job cuts but said it was likely that most of the savings would be made through sharing services like IT and procurement.
"Both airlines are already restructuring their business because of the current economic downturn," she said.
"Both Iberia and British Airways are already rolling out programmes of cost savings which have involved job losses."
Last week BA announced a record pre-tax loss of £292 million for the six months to the end of September, the first time that the airline had recorded a first half loss.
Mr Walsh said the company had reduced costs by some £400 million after manpower was cut by 1,900 roles through reduced overtime, increased part-time working and voluntary redundancy.
But he warned a further manpower reduction equivalent to 3,000 roles was planned by March next year.
The spokeswoman said tonight's announcement did not mean any additional job losses, on top of those already announced, were anticipated.
Aviation consultant John Strickland said the merger was not unexpected and BA would be keen to follow the example of an earlier deal between Air France and Dutch airline KLM.
He said: "That has been an example where jobs lost were mostly through natural wastage.
"The airlines have kept a degree of separation but benefited from working together behind the scenes and having a stronger offering in the market place.
"Both BA and Iberia have got their own problems. Both are loss- making and both have industrial issues to deal with.
"If they can get this in place for when the economy begins its recovery in 2010 or maybe 2011 then it will benefit both."
Tonight's statement said British Airways' customers would gain access to up to 59 new destinations, of which 13 will be in Latin America, as a result of a proposed merger, while Iberia's customers would gain up to 98 new destinations across the British Airways network.
Benefits would also include better frequencies and connections, more competitive prices, access to more VIP lounges and enhanced frequent flyer benefits.
Annual savings of around 400 million euros are expected by the end of the fifth year after the merger's completion.
Under the terms of the proposed merger, British Airways shareholders will receive one new ordinary share in TopCo for every existing ordinary share they hold.
Iberia shareholders will receive 1.0205 new ordinary shares for every existing ordinary share.
The statement said this will result in British Airways shareholders holding 55% of TopCo and Iberia's shareholders holding 45%.
TopCo will have its primary listing on the Official List of the UK Listing Authority and its ordinary shares will be traded on the main market of the London Stock Exchange and included in FTSE's UK Index Series.
If possible, TopCo will also have a secondary listing in the Spanish Stock Exchanges (Mercado Continuo Espanol).
Each operating company will remain responsible for its own day- to-day commercial and operational management, including staffing numbers.
Mr Walsh will become group chief executive.
A definitive merger agreement is expected to be signed in the first quarter of 2010 but remains subject to a small number of pre-conditions.
The agreement will be subject to approval from British Airways' and Iberia's shareholders.
It is expected to be presented for approval in early November 2010 at the latest, with completion expected to occur approximately one month following such approval.