I covered this yesterday so I'm going to send you over there to that thread.
Mark, if you see this, how about a FAQ on the subject? :)
It's up to you as to what you want to do with your blog. Some folks have elaborate systems of categories and subcategories and the like. I think they must have been librarians in a past life. :)
I use a fairly simple system myself.
In case of the Toronto and Canada example though, I would use both as Tags and Categories since the post would be about both. I always say that folks need to label their posts as much as possible both to help visitors as well as the search spiders. There are other cities names Toronto around the world I'm sure besides in Canada.
As to nesting, it's pretty much up to you. If you ever plan to write about other cities in canada, I'd nest.