If it comes off, the merger would create the world's 20th largest defense giant and, analysts say, give new impetus to Israeli military exports, a key revenue earner.
"This is a global trend," an IAI executive told the Globes business daily. "It happened to the government-owned defense industries in Europe. It happened in the U.S. and it will eventually happen here."
Globes said IAI, Israel's largest government-owned defense contractor, envisions a new state defense conglomerate under its leadership.
This "could more effectively compete in foreign markets on better terms than at present.
"IAI believes that the future company could do it all" develop and build unmanned aerial vehicles, upgrade combat jets, manufacture executive jets, provide state-of-the-art electronic warfare pods, build advanced missiles and manufacture armor kits for tanks and other vehicles, guided and precision artillery munitions, innovative radar system, and missile and rocket interception systems."
There has been talk before of such a merge but nothing came of it. The catalyst in this instance appears to be IMI. It's been in trouble for years and is now fighting for survival against its larger rivals.
The company is locked in a battle with Rafael Advanced Weapons Systems over developing anti-missile protection shields for the army's Merkava II main battle tank and the Namer armored personnel carrier.
The Defense Ministry favors Rafael's Windbreaker system, marketed abroad under the name of Trophy, for the Merkava.
Last month, the first tank battalion equipped with Windbreaker was deployed along the border with the Hamas-ruled Gaza Strip after Palestinian fighters damaged a Merkava with a Russian-built Kornet-E anti-tank missile.
That was the first time Hamas has employed the third-generation 9M 133 ATGM, was used extensively and with considerable effect by Lebanon's Hezbollah in its 2006 war with Israel.
Rafael, using cutting-edge technology, stepped up development of Windbreaker after that 34-day conflict in which Israeli forces performed poorly.
IMI meantime had developed a similar system called Iron Fist for the new Namer APC, on which the company pinned its hopes of a major sale to ensure its future.
In the summer, the Defense Ministry suspended its backing for Iron Fist on the grounds it wasn't battle-worthy and that Windbreaker was ready for operational use.
But senior military officers say that equipping Israel's hundreds of Merkavas with Windbreaker will take years, leaving the infantry vulnerable in their APCs.
They favor using Iron Fist for the infantry vehicles as soon as possible, a step that would put IMI back on its feet. The Haaretz daily quoted a senior former officer as saying: "IMI's system is clearly better than Rafael's.
"Whoever says anything else is mistaken and has been misled. The big scandal is that as a result of these decisions, the Namer APC will not have a new fortification system for years to come.
"That's a historic mistake, a blunder whose cost will be human lives."
Defense Minister Ehud Barak and the outgoing chief of staff, Lt. Gen. Gabi Ashkenazi, who are bitter opponents on most issues, agreed that a merger of the two systems is needed for the Namer and that IMI was pushed aside "in an unpleasant way," Haaretz reported.
According to Globes, the idea of a triple merger emerged from a December meeting involving Barak, a former chief of staff; Finance Minister Yuval Steinitz; and Ofer Eini, chairman of the Histadrut labor federation.
The meeting was called to seek a solution to the prolonged crisis at IMI which has been deadlocked for months.
In an effort to nudge IMI toward privatization, Steinitz's ministry withheld state guarantees for new foreign contracts. IMI's order book has a backlog worth $4 billion, 70 percent of which is for export.
Globes reports that IAI, flagship of Israel's high-tech defense industry and Rafael want to absorb IMI as a division under their control. IAI believes this will create "synergy" in the defense sector.
"We make the Arrow missile and IMI makes the missile's engine," an IAI executive said. "Some of its facilities are only a few kilometers from ours.
"Such a combination is natural and logical and we could incorporate IMI quickly."