The 360 would absolutely allow upscaling through HDMI, unless MS went out of its way to stop it (and that would not/will not happen). VGA was Microsoft's creative/annoying way AROUND not having HDMI.
The difference in picture quality, if existing to begin with, between a 360 using VGA upscaled to 1080p and a 360 using the supposedly on-the-way HDMI upscaled to 1080p would likely not even be noticeable. Even if the HDMI port was the newer 1.3A specification, it would still not be noticable to the vast, vast majority of people.
There is no difference in picture quality between playing a DVD upscaled to 1080p in the 360's DVD drive, and playing a DVD upscaled to 1080p in the HD-DVD add-on. None. Where do people hear this kind of stuff?