Can you do in-place updating/upgrading of Azure VM Operating System?
Nope. As per official article:
Microsoft does not support an upgrade of the operating system of a Microsoft Azure virtual machine. Instead, you should create a new Azure virtual machine that is running the supported version of the operating system that is required and then migrate the workload.
Instead, use the Windows Server Migration Tools to assist you in roles and features migration:
No, there is no such ability to upgrade an OS on the Azure VM (and not that I heard about it in future, who knows thou).
It can be done by downloading the VHD and doing the upgrade locally with Hyper-V and then reupload it.
More detailed description:https://support.microsoft.com/en-us/help/4014997/an-in-place-system-upgrade-is-not-supported-on-windows-based-azure-vms