The Japanese automaker plans to establish the new unit in January, it said in a statement, adding that its operations would be led by compact carmaker Daihatsu, a Toyota group company which was absorbed by the automaker earlier this year.
Daihatsu will be responsible for development, procurement and production preparations for compact cars while the two companies will use existing production sites to manufacture the compact vehicles.
Toyota said the companies were considering possible markets including Vietnam, India and Pakistan.
"With the establishment of the internal company, Toyota intends to learn the very fundamentals of Daihatsu's competitiveness and change the way we work," Toyota Executive Vice President Shigeki Terashi said in a statement.
The companies intend to develop Daihatsu into a global brand as they focus on growing markets for entry-level compact cars, which are becoming smaller and energy efficient due to environmental and traffic concerns.
Daihatsu holds around a 16 percent market share of the passenger car market in Indonesia, where it manufactures the Ayla and other vehicles in a joint venture with Astra International. In Malaysia, it operates a joint venture which has a market share of around 32.5 percent.