As far as I can make out, they are BSing. XP cannot be "upgrade installed" to Windows 7, in other words you need to do a clean install that'll wipe out the OS partition and install Windows 7 afresh. So whether you use the upgrade kit on the current hard drive or a new one, in either case a clean install will need to be performed.
As we know, upgrade disks can be legally used to perform clean installs provided the user owns a previous, qualifying OS such as XP that you already do. Heres a tut of how to go about it. Clean Install with a Upgrade Windows 7 Version
You'll need to use the product key you'll get with the upgrade kit.