BAT and RJ Reynolds combine forces in the US to challenge Philip Morris

British American Tobacco's subsidiary Brown and Williamson and its longtime rival RJ Reynolds have agreed to combine their American operations in a $6.2bn (£3.66bn) merger deal that promises to create a powerful competitor to Altria's Philip Morris.

They aim to create a new company that will be called Reynolds American.

The shakeup follows several years of tough legal challenges for the whole tobacco industry in the United States relating to the health hazards of smoking.

Under the deal, RJ Reynolds will agree to indemnify BAT from all current and future litigation in the US courts.

The transaction is expected to close mid way through next year, pending regulatory and shareholder approval.

However, concerns were already being raised last night that the proposed merger will face harsh scrutiny from fair competition officials.

Combined, the two companies will have control of about 30 per cent of the American tobacco market. Philip Morris would remain the dominant player.

Their combined cigarette sales in the US market should top $10bn annually.

According to the agreement signed yesterday, British American Tobacco and the current shareholders of RJ Reynolds will receive 42 per cent and 58 per cent respectively of the common equity in Reynolds American. BAT has agreed not increase its stake in the company for 10 years.

Both sides said they expected improved earnings through $500m in synergies.

Andrew Schindler, the chairman and chief executive officer of RJ Reynolds, said: "This agreement marks a milestone for both companies. The combination of these companies will enable us to achieve tremendous efficiencies, and will greatly enhance our ability to compete effectively in the US market."

RJR would also pay BAT $400m in cash to acquire the stock of Lane, a unit that distributes Dunhill tobacco and makes other products, and assume certain liabilities.

Martin Broughton, the chairman of British American Tobacco, said: "This exciting combination makes both strategic and financial sense.

"This merger will improve our competitive position in the most important cigarette market in the world. It gives the group a 42 per cent share in a stronger and more sustainable business with an enhanced brand portfolio."

The new company would consolidate its new headquarters at the Winston-Salem base in North Carolina. Brown & Williamson is currently based in Louisville, Kentucky.

Mr Schindler will be executive chairman of Reynolds American for a six-month period following the deal's closing and then serve as non-executive chairman.

Susan Ivey, chief executive at Brown & Williamson, will serve as president and chief executive of the new company.

The agreement will send tremors through the tobacco regions of Kentucky and North Carolina. Just four weeks ago, RJ Reynolds announced that it was trimming its workforce in the United States by 40 per cent amidst hard trading conditions.

Cigarette makers are facing a surge in competition from discount manufacturers in the American market, which have increased market share as smokers, hit by sharply increased taxes in many states, seek cheaper alternatives to the established brands.

The industry is also battling cigarettes that are smuggled as well as brands produced by North American Indian tribes, who have special dispensation from federal taxes.

The litigation drama reached a crescendo in 1998 when the tobacco industry reached a $280bn settlement with US states seeking damages for covering public healthcare costs.