I agree that users ought to be able to use the app without granting access to location data (opting out of #2). But unfortunately, if Apple provides no way of inferring screen time without use of location, this category of app is impossible.
Multitasking apps may only use background services for their intended purposes: VoIP, audio playback, location, task completion, local notifications, etc. If your app uses location background mode, include a reminder that doing so may dramatically decrease battery life.
Screen time inference is clearly not an intended purpose for location, since the actual location data obtained has no connection to it (i.e. to #1 above; note we're interpreting "purpose" from the user's perspective). It sounds like the rep is misinformed, or that the TOS needs to be updated with an explicit exception.
Etc here could allow almost everything or nothing. Depending on what argument you want to push.
Ultimately it’s Apple‘s walled garden and they have the final say.
[citation needed]