The merged companies would have combined sales of more than $90.3 billion and more than 220,000 employees.
The deal would create a global aerospace and defense giant in a sector facing challenges and uncertainties amid cuts to government defense budgets in Europe and the United States.
EADS is already one of Europe's biggest companies, parent to planemaker Airbus, helicopter maker Eurocopter, satellite builder Astrium and defense electronics contractor Cassidian.
Airbus and EADS have long been rivals to U.S.-based Boeing in civil and defense aviation.
The companies confirmed discussions in a statement to the London Stock Exchange on Wednesday, saying that under the proposed merger, BAE Systems shareholders would own 40 percent and EADS shareholders 60 percent of the enlarged group.
The deal would unite the companies' boards and management but they would continue to be listed separately on stock exchanges, the statement said.
BAE and EADS pointed to a "long history of collaboration" on projects such as the Eurofighter Typhoon jet, which is partly assembled in Britain and then built by EADS elsewhere in Europe.
EADS would have to pay $322.1 million to its shareholders prior to the completion of any deal in order to align the companies' different dividend payout policies.
U.K.-based BAE and Netherlands-based European Aeronautic Defense & Space Co. acknowledged the sensitive nature of their global businesses and said they had initiated discussions with "a range of governments" about the implications of a merger.
IHS Jane's analyst Guy Anderson said the proposed deal would change the European defense market beyond recognition, which could pose a tough sell for regulators.
"This is potentially bigger than the Euro merger of '99 which created EADS," Anderson said. "The call for consolidation to save the European defense industries has been ringing out for years now, and with this it appears to be happening in a bigger way than ever hoped."
With BAE and EADs already cooperating on Eurofighter and owning two of the three parts of the MBDA missile making group, a merger would change ownership structures across Europe, and Anderson said regulators would need convincing that it won't crush competition.
"It will probably take a while to unravel all the details and find the actual degree of overlap," Anderson added.
The British government said it was aware of the proposed deal and was working with both companies "to ensure that the U.K.'s public interest was properly protected."
The companies said they envisioned that certain defense projects of each company "would be ring-fenced with governance arrangements appropriate to their strategic and national security importance."
They also envisioned issuing special shares in BAE and EADS to each of the French, German and U.K. governments to replace existing government stakes in the two companies.
Any agreement on the terms of merger would require approval by the boards of both companies, according to the stock exchange statement.
The companies have until Oct. 10 to announce a deal or walk away from a merger.
BAE, which produces Astute nuclear-powered submarines and is the largest supplier of land vehicles to the U.S. army, last month reported a slight dip in first-half profits and cautioned about its U.S. outlook amid uncertainty over defense spending ahead of November's presidential election.
BAE shares closed up 10.6 percent at 3.63 pounds ($5.84) on the London Stock Exchange. In Paris, shares of EADS dropped 5.6 percent to 28 euros ($36.11).
Associated Press reporters Angela Charlton in Paris and Jill Lawless in London contributed to this report.
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