Air Canada CEO Calin Rovinescu said the creation of the new travel company is a major milestone for the airline.
"Our new leisure group will benefit from combining the low-cost carrier with the strong brand reputation of Air Canada Vacations and leveraging the established marketing and distribution channels of both Air Canada Vacations and Air Canada," he stated.
"As a result, Air Canada will be able to compete more effectively in this highly dynamic and expanding market."
Details about the carrier's name, schedule and product offering will be disclosed later this fall when Air Canada releases its 2013 schedule.
Michael Friisdahl, former CEO of Thomas Cook North America, has been appointed to lead the new wholly owned subsidiary. He will report to Air Canada's chief commercial officer Ben Smith.
The new low-cost airline will begin operations with two Boeing 767-300ER and two Airbus A319 aircraft that will be released from Air Canada's mainline fleet.
Additional planes will be added as Air Canada (TSX:AC.B) starts to take delivery of new Boeing 787 Dreamliner aircraft in 2014, ramping up to 50 planes.
The new travel company will serve holiday destinations in Europe and the Caribbean that didn't generate adequate profits under Air Canada's existing cost structure.
Air Canada plans to hire more than 900 employees over the next 12 months for the main airline and another 200 flight attendants and pilots for the new low-cost carrier.
Industry observers said that while the new low-cost carrier model is beginning to take shape, it won't pose a large competitive challenge or have a big financial impact for Air Canada for some time.
"What I think it does is protect them in certain markets where a lot of the low-cost carriers have been taking share," said Chris Murray of PI Financial Corp.
"It also affords them the opportunity to serve some markets that they haven't previously, but I don't think it overly impacts their core business, at least in 2013 and I'd say in 2014 at this point."
In fact, Air Canada's chief financial officer recently warned analysts that the low-cost carrier won't have a material financial impact next year.
Murray described the combination with Air Canada Vacations as a "minor positive" but a good idea.
David Tyerman of Canaccord Genuity said the structure is a logical way to start and gives Air Canada the chance to "get their feet wet and figure some of this out."
The new entity is designed to challenge rivals such as WestJet Vacations, Sunwing, TUI Vacations and especially Transat AT (TSX:TRZ.B), he said.
"It's going to be a challenge for Transat, I would think," he said in an interview.
"They're the only ones really affected on the long haul side of it and on the short-haul they and Sunwing would probably be the most comparable because they both run high-density aircraft."
Tyerman called the new carrier a "low-end play" that could attract bargain-seeking passengers, but at the risk of turning off higher-end customers that currently fly on the mainline carrier.
Planes will be crammed full with seats. Air Canada's A319 planes have 120 seats including premium class. Low-cost U.S. carrier Allegiant will fly the same planes with 156 seats.
Air Canada has said about half of incremental profits from its low-cost carrier will be derived from cramming more seats into a fleet of 20 Boeing 767s and 30 Airbus A319s. The rest comes from lower employee wages and more flexible work rules.
The wide-body planes, for example, will be fitted with 20 per cent more seats, raising the number of passengers to 275 per aircraft.
Tyerman said the low cost carrier is probably good news for consumers, depending on how quickly the new planes are added to the network.
"If they're added in aggressively, then the capacity will be raised and that's always good for the consumer," he said.
"If they're added in a relatively slow manner it may not make much difference because the market does grow over time so they may just be picking up the growth in the market."
Air Canada is Canada's largest domestic and international airline and 15th largest in the world, serving more than 175 destinations and 33 million customers a year.
On the Toronto Stock Exchange, its shares gained four cents to close up three per cent to $1.35 in Tuesday trading.