When I transfer money from my bank to PayPal, where does the money actually go behind the scenes?

Your money is being held in escrow by one of the various banks that PayPal works with. For example if you transfer money from your small community bank to PayPal, your balance would be held with Bank of America (as an example), under PayPal's account, under an escrow/nostro account for your PayPal ID.

The funds are held on behalf of PayPal by the bank.