The last step is the problem. iOS subscriptions work on a collection level, not an app level. After you create the subscription product, you need to assign that product ID to one or more collections, not to the app itself.
I'm curious. Why do you want to set up a free subscription? Apple introduced free subscriptions back when background downloads worked only in Newsstand apps, and free subscriptions were the only way to get an app with free content into Newsstand. Now that background downloads are supported in non-Newsstand apps and Newsstand is going away, why do you want to provide free subscriptions? Perhaps you want to obtain information about the user? Unless you have a compelling reason, I recommend that you avoid adding subscriptions to your app.
Apple made you submit an in-app subscription because you have the "Newsstand" option selected in the Apple developer site. If you edit your app in the Apple dev site and deselect Newsstand, you won't be required to submit an app with subscriptions. If you don't want your app in Newsstand, you could reject the submission now, edit the app product to deselect Newsstand, and then rebuild your mobileprovision files (and push notification files, if you have them), re-build the app with these updated files, and then resubmit the app.
At one point, Apple didn't let you switch from a Newsstand app to a non-Newsstand app, but I think they allow that now.
[Note: I just tested this on the Apple developer site, and I no longer see a "Newsstand" option when I edit an App ID. I think you should rebuild your mobileprovision file and try again.]
Thanks for following up. Even though I written about this quirk in the iOS Publishing Guide, I had forgotten about it:
Apps that have Magazine in the category or sub-category setting in iTunes Connect must be enabled for Newsstand. If you don't want your app to be in Newsstand, do not select Magazine as a category or sub-category.
Looks like Newsstand has indeed been pulled from the app developer site under the options list. I rebuilt the mobileprovision file, and made sure newsstand was unchecked in AEMM. That got me over the first hurdle. However, In order to submit, I still couldn't assign "Magazine or Newspaper" as a category. That category still required me to turn Newsstand back on and create a free subscription purchase. So I just used a more generic category classification with no in-app purchases and everything went through. I was able to submit / publish the app successfully.
SO..Why a free subscription? I totally agree with your reasoning and conclusion. It goes like this: Once I finished creating the app, I sent the build to iTunes. it was rejected with the specific instruction to make newsstand=true. That was weird - as you said - I thought that was phasing out. Regardless, I followed the instructions. So I enable the newsstand checkbox and resent the app. The build was now accepted. When I started filling out the App info, since I had categorized it as a magazine, it said I was **required** to create an in-app purchase free subscription. I could not submit the app without doing so. So I went back and created the subscription.
I would love nothing better than not to deal with subscriptions - the whole thing seemed unnecessary for all the reasons you mentioned above. I think I will not attempt submission again, but go back and try to figure why it flagged me for newsstand initially. No point in all this. Very frustrating.