The deal, which creates a group with a combined market value of around $8 billion, majority owned by BA shareholders, ends the British company's long pursuit of Iberia, and will allow it to emulate rivals Lufthansa
The terms and conditions of the merger agreement are in accordance with the memorandum of understanding signed by both airlines in November, the companies said in a joint statement.
The merger will give the two loss-making airlines the scale they need to ride out the industry downturn and compete with larger rivals and budget carriers such as Ryanair
BA and Iberia shareholders will be asked to approve the deal in November, the merged company will be headquartered in London.
The new firm, which will have annual revenues of around $20 billion, combines BA's strong position in Europe-to-North America with Iberia's Latin American business, and could be reinforced by a planned alliance with American Airlines
The agreement comes after recent strikes by BA cabin crew in a dispute over pay and jobs, which cast doubt on BA's future.
The merged entity, which will fly with 408 aircraft and 200 destinations by the end of 2010, could cut less profitable short-haul flights and compete better on the routes it retains.
BA and Iberia target annual synergies of about 400 million euros by the end of the fifth year as one company.
The pair began merger talks in July 2008 in response to slowing passenger demand but industry body IATA last week said airlines were slowly climbing out of recession.
(Editing by Elaine Hardcastle)