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"
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.
Guy#1: Woah, this babe in front of us has an awesome figure!
Guy#2: Wish she'd turn around so we can see her face.
*girl turns around and her face turns out to be ugly*
Guy#1: Daaaaamn!
Guy#2: What a paper bag!