A paper bag is the opposite of "Lollipop". It is used to describe a girl or guy who has a hot body but an ugly/plain face. It's called paper bag because you metaphorically want to just a paper bag on the person's face.
1 When you are having sex with a really ugly girl and you put a paper bag over her head to cover her uglyness
2 When your buddies make fun of you for liking a girl who is really ugly and you simply reply "paper bag it" as a response meaning "who cares"