They expect the deal, which follows a provisional agreement reached at the end of last year, to be completed by the end of 2010.
The merger will save the airlines euro400 million ($530 million) a year by the fifth year and will benefit shareholders, customers and employees, the carriers said. Both will continue to operate under their individual brands.
With 408 aircraft flying to 200 destinations, carrying more than 58 million passengers each year, the merged group would become the third largest in Europe and the sixth largest worldwide.
"The merged company will provide customers with a larger combined network," said BA Chief Executive Willie Walsh. "It will also have greater potential for further growth by optimising the dual hubs of London and Madrid and providing continued investment in new products and services."
The announcement of a firm deal comes as loss-making BA fights an acrimonious battle over pay and working conditions with its 13,000 cabin crew. Staff went on strike twice for a total of 10 days last month, costing the airline some 40 million pounds.
Like other airlines, both BA and Iberia have been hit by a downturn in passenger demand since the global credit squeeze and they acknowledge that more consolidation of the industry is likely.
They said the merger deal, which is subject to regulatory approval from the European Commission and to approval by both British Airways and Iberia shareholders, is structured to take advantage of that anticipated further consolidation.
"This is an important step in the process towards creating one of the world's leading global airlines that will be better equipped to compete with other major airlines and participate in future industry consolidation," said Antonio Vazquez, Iberia's chairman and chief executive.
Both airlines will retain their current operations and operate under their individual brands.
The transaction will be implemented through the creation of a new holding company called International Consolidated Airlines Group SA which will be known as International Airlines Group.
British Airways shareholders will receive one new ordinary share in International Airlines Group for every existing British Airways ordinary share held and Iberia shareholders will receive 1.0205 new ordinary shares for every existing Iberia ordinary share held.
The treasury shares held by Iberia and the cross-shareholdings held by British Airways and Iberia in each other will not be eligible for International Airlines Group shares.
International Airlines Group will be listed on the London Stock Exchange.
The pair plan to hold shareholder meetings for approval in November.