IMHO, Google is a VERY rational (not to mention ridiculously smart) group of people whose main goal is to deliver relevant content to the searcher based on the chosen keywords.
Internal linking is good for SEO and for usability.
That said, Vanessa Fox, an ex-Googler (I forget her exact position), said, "
Google is no longer treating subdomains (blog.widgets.com versus widgets.com) independently, instead attaching some association between them. The ranking algorithms have been tweaked so that pages from multiple subdomains have a much higher relevance bar to clear in order to be shown.
It?s not that the ?two page limit? now means from any domain and its associated subdomains in total. It?s simply a bit harder than it used to be for multiple subdomains to rank in a set of 10 results. If multiple subdomains are highly relevant for a query, it?s still possible for all of them to rank well."
Rest of that post here:
Subdomains or Subfolders : Which are Better for SEO?