There's absolutely nothing wrong with a habitable building incorporating retaining walls provided they're detailed and built right. But I wouldn't be incorporating this wall, a gap will be fine provided there's a gap big enough to sweep any leaves/crap out and on the assumption the retaining wall is adequate. Ensure the gulley slopes towards the open ends.You really dont want a habitable building wall retaining earth unless its unavoidable.
The wall of my extension will be approximately 120mm away from a 1.2 metre high retaining wall. Do we need to tank either the new or old wall or will the air space be sufficient?
there will be an open gully along the base of the wall going into the rainwater drain.
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