Looking at the Paypal User Agreement on their site, it looks like there may not be a way to get around this (and it might actually be something that Paypal is doing to limit risk to themselves):

Payment Source Limitations. In order to manage risk, PayPal may limit the Payment Sources available for a transaction. In such a case, you may choose to continue with the transaction with the understanding that you may have fewer avenues available for dispute resolution should the transaction turn out to be unsatisfactory.

I think a good workaround might be to purchase an iTunes gift card using Paypal (or some other payment source), add the giftcard balance to your iTunes account, and use that balance for iTunes purchases.