Channel transmission losses alter the streamflow response of arid and semiarid watersheds and promote focused groundwater recharge. This process has been primarily studied in dryland channels draining large areas that are displaced away from hillslope runoff generation. In contrast, small watersheds on arid piedmont slopes allow the investigation of interactive hillslope and channel processes that control the partitioning between surface and subsurface flows. In this study, we utilize high‐resolution, long‐term measurements of water balance components in an instrumented watershed of the Chihuahuan Desert to set up, parameterize, and test a process‐based, distributed hydrologic model modified to account for channel losses. A transient method for capturing capillary effects in channels results in simulations with a reliable representation of the watershed energy balance, soil moisture dynamics, hillslope infiltration, channel transmission (or percolation) losses, and streamflow yield over the study period. The simulation also reproduces a conceptual model of hillslope infiltration‐excess runoff generation linked to downstream channel percolation losses that depend on the rainfall event size. Model‐derived thresholds were obtained for the amount of hillslope runoff (6 mm) and rainfall (12.5 mm) necessary for streamflow yield, such that 40% of percolation occurs for small events that do not reach the outlet. Using a set of scenarios, we identify that hillslope infiltration controls the rainfall threshold necessary to initiate percolation, while channel infiltration affects the partitioning into percolation and streamflow yield. Thus, the connectivity along hillslope‐channel pathways is deemed an essential control on the streamflow generation and groundwater recharge in arid regions with complex terrain.