I have been working in SEO for over 10 years and have built search agencies from the ground up. I've also worked with some big brands on International SEO like Active.com, as well as many US based chains like Extended Stay Hotels.

I suggest sub-directories as they are MUCH easier to manage and promote via SEO.

You can't have specific local IPs with sub-directories, but you can with sub-domains. But that's not hyper critical, there are WAY more important factors. Plus, you can geo-target in Google Webmaster Tools. Your current structure for sub-directories is perfect: http://drivingtests101.com/Canada/Ontario

With subdomains, each will be treated like a brand new site. So you would have to work very hard to get each to gain good authority SEO-wise. Plus managing and hosting lots of subdomains is a ton of work!

In order to not get penalized you need to:
Implement the the "lang" and "hreflang" tags in the HTML of each country directory and all pages within.

Have unique Title tags and descriptions written in each language.

Have unique content for each country and state page. Written in each respective language.

Yes, its a TON of work but hey, you are trying to take over the world! If you are serious about international search traffic then you will do these things and the costs should be balanced out with the extra traffic you'll get. If you can make the root domain super authoritative then it will boost ALL of the internal pages. This is also key to ranking well for international search.

I'm open to a follow up call to elaborate on any of my responses or to answer other questions.