I currently manage a German/English site. I don't use a sub domain, but rather just a www.domain/de/ for the pages in German.

With regards to the umlaut's... Just searching through my stats, we get far more hits using the umlauts vs typing in the appropriate ae, oe, ue, ss.

The only time I believe they might use these substitues is when they are entering a URL. You run into all sorts of problems using special characters in your URL's - so it's best to use the substitutes for filenames.