The vehicle, which is rumored to be called Beduin, will be built at VW's plant in Portugal alongside the new Golf-based cabriolet that will be unveiled at the upcoming Frankfurt Motor Show.
The small SUV will compete with Toyota's RAV4 and BMW's X3 in an increasingly crowded compact 4x4 sector. The car is expected to be unveiled at either the Geneva or Paris Motor Show next year and will go into production in 2007.
Building the car in Portugal will save VW $1,220 (£674) per vehicle, compared with building it in Germany, the company told the Financial Times.
The paper said this was a way of putting pressure on German unions to agree to ways of lowering VW's German labor costs.