Convert to Smar Object command"Knockout" is a blending option, turning a layer to a kind of a mask for all underlying layers except for the Background layer.
To create this effect:

  1. Choose a layer in the Layers palette.
    (On this screenshot - "Shape 1")
  2. In the Effects palette, double-click the "Knockout" thumbnail.
  3. If you want to punch through the Background (to transparency), convert it to regular layer (Layer > New > Layer from Background) or simply hide it (screenshot).
  4. Convert to Smar Object commandTo turn off the effect double-click the "Disable Knockout" pictogram in the Effects palette.

Attention! When you apply the "Knockout" to a shape layer, the Custom Shape and other shape tools tend to remember the effect and apply it to follow-up shape layers. To resolve this, you may need to use the "Disable Knockout" action after drawing the next shape.

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Kockout effect on the layer