The New Zealander, making his first top-level WRC gravel start for eight years, reached Friday's midday service 23.9sec clear of M-Sport Ford's Josh McErlean, with championship leader Elfyn Evans just 2.8sec further back in third.
Sami Pajari was fourth at 33.2sec, while Paraguayan Rally2 star Diego Domínguez completed a remarkable morning in fifth overall.
Few could have predicted that order after Oliver Solberg dominated the opening exchanges.
The Toyota driver was immediately on the pace, winning Cambyreta by 3.1sec from Adrien Fourmaux and then doubling his advantage to 7.1sec on Nueva Alborada. Paddon sat second at that point, with Fourmaux third.
But the rally had already begun taking a heavy toll.
Takamoto Katsuta rolled his GR Yaris Rally1 barely two kilometres into the opening stage and retired, while Thierry Neuville damaged the left-rear suspension of his Hyundai after going wide over a jump. The Belgian reached the finish after losing almost three minutes but went no further.
Sébastien Ogier's morning unravelled just as quickly. A rear-left puncture cost last year's Paraguay winner 24.4sec on SS1 before he struck a bank on Nueva Alborada and broke a suspension arm. Ogier made temporary repairs and attempted the following Yerbatera test, only to stop when his makeshift fix failed.
It was the 33.88km Yerbatera which completely transformed the leaderboard.
Solberg's engine stopped under braking 5.7km into the stage, leaving his Toyota stranded until spectators were able to push-start it. A slow rear-right puncture then forced him to stop again for a wheel change and he surrendered almost four minutes.
"There was no overshoot," Solberg explained. "The engine stopped on the braking and then I couldn't get it started. I had to wait for some people to push the car. Then all of a sudden on a straight line we had a slow puncture."
Fourmaux was next to suffer, stopping to replace a delaminated front-left tyre and losing 1min 27.9sec.
Evans nursed a delaminating rear-left tyre through much of the stage, Pajari experienced the same problem at the front-left while already managing a water leak, and McErlean reached the finish with a tyre beginning to come apart.
Amid the chaos, Paddon stayed out of serious trouble and produced the fastest Yerbatera time by 17.2sec to vault from second into a commanding lead. He then safely negotiated the short Autódromo Alfredo Scheid test to reach service at the head of the order, marking his first WRC rally lead since Rally de Portugal in 2018.
"I've probably learned in life you have to savour these moments a little bit as well," he said. "It's pretty special to think after all this time to be in this position.
"A few circumstances have worked in our way, but it's pretty cool. Anyway, we have to reset and focus and try and do the same this afternoon."
McErlean's measured approach was rewarded with second place after the Irishman avoided the worst of the problems which struck those around him. He sits only 2.8sec ahead of Evans, with both firmly in contention.
"It's been a good morning," McErlean said. "We have to be really satisfied with that. Big afternoon ahead, so let's keep the momentum going. Whenever you're fighting for WRC podiums, it's not that bad."
Evans, opening the road as championship leader, was similarly relieved simply to have survived a loop which produced problems seemingly everywhere.
"I haven't looked too much at the overall," he admitted. "There is so much going on. There are so many punctures, it's unbelievable."
Pajari sits 6.5sec behind his Toyota team-mate in fourth despite spending much of the morning managing a water leak, while Domínguez is an impressive fifth, 1min 29.5sec from Paddon's lead.
Fourmaux recovered to sixth after setting the fastest time on the morning-closing super special, with M-Sport's Jon Armstrong seventh despite a high-speed spin and brake problems on Yerbatera. Gus Greensmith completed the top eight.